Economist filter: How exactly does the fed set interest rates?

June 29, 2007 12:18 AM

Economist filter: How exactly does the fed set interest rates?

I've done a couple google searches but would love it if someone can give me a short, human-being explanation or point me to a really good article on the topic.

posted by BigBrownBear to work & money (9 comments total)

I am currently studying econ at the undergraduate level but I am by no means an expert in the field. Here's my stab at answering your question:


The Federal Open Market Committee, a group comprised of the members of the Federal Reserve Board and the presidents of the Federal Reserve Banks, sits down together every six weeks and examines the condition of the economy. During their session, they vote on a target interest rate for the following six weeks. Once the interest rate has been chosen, the Fed's bond traders then conduct open-market operations, buying or selling bonds to shrink or expand the money supply. These actions in turn cause the equilibrium interest rate to adjust to the rate chosen by the FOMC. So, in essence, when the Fed changes the money supply, it really does so by manipulating the money supply.

I'm sure someone will give you an even better explanation so no worries if it's still not clear. And I probably made a bajillion errors because it's so late.
posted by roomwithaview at 12:33 AM on June 29, 2007

Erm, error number one: "So, in essence, when the Fed changes the money supply interest rate, it really does so by manipulating the money supply." Sorry!
posted by roomwithaview at 12:34 AM on June 29, 2007

so they manipulate the money supply by offering bonds that suck up liquidity?
posted by BigBrownBear at 1:10 AM on June 29, 2007

or the other way around...
posted by BigBrownBear at 1:10 AM on June 29, 2007

That would be the discount rate that banks pay at the Fed discount window in NYC, the banks in turn lend at a higher rate. William Greider's book is a good source on the inner workings of the Fed.
posted by hortense at 1:17 AM on June 29, 2007

Secrets of the Temple is out of date -- the discount rate is largely symbolic these days, since banks wish to avoid the auditing requirements for money borrowed from the Fed. The federal funds rate is the rate at which banks lend one another "federal funds" (no-interest deposits with the Federal Reserve) to meet reserve requirements.

In a sense, the federal funds rate is the cost of short-term cash on hand to a bank that's part of the Federal Reserve system; since such banks are among the lowest-risk borrowers in the world, it's also essentially the lowest possible cost of cash on hand for corporations and individuals, as well. So, when the Fed increases rates by a half-point, the annual cost of carrying $100 in your pocket (whether it's the cost of borrowing the $100 or the opportunity cost of not having it in a savings account) goes up by at least $0.50.

The Fed boths buys and sells bonds (and other things, but it's easier to just say "bonds") to maintain the federal funds rate at the target. If the rate creeps up, the Fed will buy bonds with, in effect, newly-created money which will increase the money supply and bring the rate back down. The opposite happens when rates go down, with money being taken out of circulation by selling bonds. Note that these bonds come from the Fed's own stock; the whole idea is to give the Fed the agility and capability to regulate the money supply in real time regardless of the US government's debt situation.
posted by backupjesus at 4:06 AM on June 29, 2007 [1 favorite]

The Bank of England has page which explains how monetary policy works. The US process is the same with different terminology.
posted by TrashyRambo at 7:16 AM on June 29, 2007

Central to the central banking system is BIS
posted by hortense at 9:41 AM on June 29, 2007

The key point to understand is that the Fed buys bonds with money that it prints. It used to be that money was backed with gold in a vault. Now the backing for money is treasury bonds. The Fed virtually never sells bonds in agregate. The rate at which the Fed buys bonds influences the overall demand for bonds, which means that the price of the bonds falls when they buy more (hence higher interest rates), and rises when they buy less (hence lower interest rates. Since the Fed is printing money in order to pay for the bonds, buying bonds increases the money supply. If you have more dollars in the economy, all else being equal, prices will rise. This is what causes inflation. Therefore, the fed can decide to lower rates and increase inflation, or increase rates and lower inflation. All of these things of course, are relative though. If the productivity of the economy is increasing fast, the natural effect would be to have strong deflation. In this circumstance, the Fed could keep interest rates low without causing much inflation. This was the situation in the late nineties, and today as well.
posted by cameldrv at 1:10 PM on June 29, 2007