Why the Fed changes interest rates: Explainer

 

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No matter the direction, up or down, when the Federal Reserve adjusts its headline interest rate, the global economy moves. Eight times a year, journalists, analysts and investors around the world carefully monitor the Fed’s arcane statements for hints of where the economy is heading.

What’s the Fed?

The Federal Reserve – widely known as “the Fed” – is the central bank of the United States. It is run by a seven-member Board of Governors appointed by the president and approved by the Senate to 14-year terms, which are staggered so that no president may appoint all members. In this way, it is nominally independent.

The president also appoints the chair and vice chair of the board to four-year terms, which are often renewed once. Janet Yellen took over as chair after her Senate confirmation in February 2014.

The Fed is headquartered in Washington, D.C., and supervises 12 district branches around the country, such as the Federal Reserve Bank of Chicago and the Federal Reserve Bank of Atlanta.

All seven governors serve on the 12-member Federal Open Market Committee (FOMC) along with the president of the Federal Reserve Bank of New York and four of the remaining 11 reserve bank presidents, who each serve one-year rotating terms.

Setting monetary policy

The FOMC meets eight times a year to set monetary policy – “to influence the availability and cost of money and credit to help promote national economic goals.” Basically, the FOMC manipulates the amount of money in circulation in order to keep unemployment low, inflation at around 2 percent and forestall recessions.

To meet these goals, the Committee sets a “federal funds target rate.” It then influences the supply and demand for cash in circulation (a process it calls “open market operations”) by buying or selling government-backed securities — printing money, effectively, to lower the rate; or buying and hoarding money to raise it. The FOMC can also tweak the amount of cash that banks are required to hold outside of business hours. To meet these requirements, the banks borrow and lend to each other overnight at a rate very close to the Fed’s target. The weighted average rate for these transactions is the “effective federal funds rate.”

The federal funds rate has wide implications. Private lenders adjust their rates accordingly. So, if you are borrowing money to buy a home or start a business, you will likely pay an amount your bank calculates based on this rate (but higher, because the bank expects a profit).

Thus, the Fed has enormous influence over the business cycle. Lower rates stimulate growth by encouraging borrowing and investment; higher rates stifle spending, slowing growth and inflation. This all happens slowly, though, making fine tuning the economy a risky and constant work-in-progress.

The federal funds rate also impacts the dollar. If the rate climbs, foreigners become attracted to the returns (they already like the security) of American banks, and money flows into the U.S. That strengthens the dollar against other currencies, making American exports more expensive to foreigners, but also making a Tahitian vacation or a hunk of Camembert cheaper for Americans who earn dollars. Consequently, foreign central banks adjust their own rates. If the federal fund rate goes down, foreigners take their money out of the U.S.; that reduces demand for dollars on international currency markets, pushing the value of the dollar down (Camembert gets more expensive).

This is why business journalists get so excited by the FOMC’s post-meeting statements – and, three weeks later when it releases its minutes – scouring these documents for insights into officials’ thinking about the economy, and thus how they expect to move interest rates. Alone, a suggestion about a future rate change can move markets.

Impact and inflation

Since the Great Recession of the late 2000s, the Fed has kept the federal funds rate at historic lows to stimulate the economy. With interest rates around 0.25 percent, borrowing for most Americans is cheaper and easier. One side effect has been soaring house prices, which have grown much faster than inflation as more people have rushed to buy homes with this “cheap money.”

Sometimes, to tame inflation, the Fed increases the rate. In 1981, the effective federal funds rate surpassed 19 percent. That made borrowing difficult for many people, which was the point: When people have less cash to spend, inflation falls.

Nominal vs. real interest

You may hear officials and analysts talk about “real interest rates.” That is the interest rate adjusted for inflation – a “real” figure is what money is worth after inflation has been subtracted. A “nominal” rate is the amount without considering inflation – the amount in name only.

If a bank will loan you money to buy a house at 4 percent for 30 years, are you paying 4 percent? Right now, no. The Fed expects inflation over the next 10 years to hover around 2 percent. So, if you receive a 30-year loan at 4 percent interest, you are really paying about 2 percent (4-2=2) as long as inflation remains around 2 percent and your salary keeps up with inflation.

Finding data:

Each member bank within the Federal Reserve system publishes regional data. Some offer other specialized projects. For example, the St. Louis Fed hosts the vast database from which we drew the above graph. Here’s a list of the 12 banks’ homepages.

Each morning, the New York Fed publishes the overnight rate, the target federal funds rate and the volume of overnight trading.

We at Journalist’s Resource put together this tip sheet on how to find data on house prices.

Other resources:

  • Loved by business students, Investopedia is a good dictionary of economics and finance terms.
  • The U.S. Department of the Treasury is the federal agency responsible for managing the government’s money, printing money, advising the president and implementing economic sanctions against foreign threats. The treasury secretary is appointed by the president and approved by the Senate.
  • Here is a list of foreign central bank websites.

    Writer: | Last updated: February 2, 2017

     

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