How the Fed affects interest rates

Q: What is the Fed and how does it affect interest rates?

A: The Fed is short for the Federal Reserve, an independent entity created by Congress in 1913 to help promote a sound banking system and a healthy economy. When you hear in the news that the Fed has decided to raise or lower interest rates, what it actually means is that the Fed has set a target for what is known as the federal funds rate, the rate banks charge each other for overnight loans.

By influencing the federal funds rate, the Fed can impact consumer interest rates charged by banks on all types of loans, from car loans to credit cards. Generally, when the Fed raises rates, your cost to borrow money goes up. This affects many consumers directly, as interest rates on credit cards and home equity lines of credit are not usually “fixed” like a mortgage, and thus the rate can increase or decrease along with the Fed’s actions. The Fed influences interest rates in three main ways:

It sets the discount rate eligible banks are charged to borrow funds on a short-term basis from a Federal Reserve Bank. While the rate is "discount" in that it is usually lower than the actual federal funds rate, banks tend to raise or lower their rates in tandem with this rate. If the Fed increases its rate, then banks essentially pass on to consumers the higher rates that they have to pay.

Mortgages are only indirectly affected by the federal funds rate. The real influencers of mortgage rates are the five-, seven- and 10-year Federal Government Treasury bills (T-bills). Since these have the same lifespan as most mortgage loans, mortgage rates are priced at a premium to these bills (a slightly higher interest rate).

It sets the reserve requirements or amount of funds that banks are required to hold on reserve in relation to their deposits. Usually, banks are required to hold around 10 percent of their deposits on reserve. Because their reserves often fall below this requirement during their day-to-day business transactions, banks frequently borrow from each other’s reserves at the federal funds rate.

It buys and sells U.S. government securities (such as T-bills, notes and bonds) on the open market to influence the level of reserves held by banks. To increase the target federal funds rate, the Fed sells securities. The money it collects is removed from the reserve accounts of the banks involved in the sales so the banks end up with less on reserve. As a result, they’re more likely to need to borrow to make up a shortfall and the increased pressure on intra-bank lending tends to drive up the federal funds rate.

The reverse is also true. If the Fed buys securities, the money it pays is credited to the reserve accounts of the banks. The banks end up with more on reserve and less need to borrow. This has the effect of driving interest rates down.

Learn more about the Fed.

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