Who is the Federal Reserve and Why Are They Messing with Interest Rates?
If you are someone who enjoys reading the news and keeping up with what is going on in the world, you may have come across more than a few articles mentioning the Federal Reserve and something about raising rates and what it could do to the stock market. While the media may make it sound like the end of the world, managing interest rates is an important part of the Federal Reserve’s job.
The Federal Reserve System was created in 1913 in response to the Banking Panic of 1907 which pitted private banks against more “progressive” consumers. To resolve this issue, President Woodrow Wilson signed the Federal Reserve Act, which created a decentralized bank that could help moderate the relationship between the private banks and the people who used them. Today, the Federal Reserve exists as a series of branches across the U.S. (12 in total), which all fall under the Federal Reserve Board of Governors located in Washington D.C.
The Federal Reserve is uniquely structured as a hybrid of private and public elements. The individuals who serve on the board are not elected but appointed and are called to testify before congress throughout the year. The system serves a variety of purposes including tracking economic trends, providing economic research, supervising the financial industry, and guiding monetary policy.
Broadly speaking, the Federal Reserve has what is known as a dual mandate: 1) stable prices (which could be rephrased as “low inflation”) and 2) full employment. The two goals can sometimes be conflicting. For example, a strong job market can lead to inflation. Conversely, a recession can lower inflation but put jobs at risk.
The Federal Reserve uses interest rates as a key policy tool to achieve its dual mandate. Traditionally, economists consider lower rates as ‘stimulative’ to the economy since lower interest rates encourage borrowing for both consumption and investment. Lower interest rates are sometimes call “easy money” or “loose policy.” Higher interest rates are considered “restrictive” since they increase the cost of borrowing and discourage consumption and investment. Higher interest rates are sometimes called Fed “tightening.”
In practice the Federal Reserve adjusts interest rate policy based on what is happening in the economy. If inflation is too high, the Federal Reserve will often act to raise interest rates to slow the economy and curb inflation. If the economy slows too much, there can be a recession. If there is a recession, unemployment rises, and the Federal Reserve will often act to lower interest rates to stimulate the economy. If the job market becomes too tight, inflation can rise to unacceptable levels, bringing the Federal back to tightening and the cycle begins again. This cycle of raising and lowering interest rates is sometimes called the business cycle.
When journalists talk about the Federal Reserve raising rates, it is important to understand that the Federal Reserve is not in charge of all interest rates, though they do influence them. The Federal Reserve is in charge of deciding what the Nominal Federal Funds Rate should be. The term nominal refers to what the Federal Reserve wants the rate to be, not necessarily what it is. The actual Federal Funds Rate is the average rate of all the rates that banks are lending to each other at. The Federal Reserve influences this rate by requiring banks to hold a certain amount of money in reserve, thereby requiring them to lend or borrow to meet that requirement, which in turn affects the rates the banks charge each other. What results is a trickle-down effect. The rate that the big banks lend to each other affects the rates that the big banks lend to smaller banks.
It is important to understand that the Federal Reserve does not determine the interest rate that the banks charge to business and individuals like you and me. The Federal Reserve impacts the ‘cost of money’ to the banks, which influences the rate they charge. However, banks determine their own rates based on many factors including inflation, economic outlook, strength of the borrower, and the bank’s expectation of the direction of interest rates.
Therefore, banks will often raise rates simply on the expectation that the Federal Reserve will raise rates, which is why Federal Reserve statements and expectations are important – almost as important as the actual steps that they take. It is also why interest rates and stock market prices adjust before the Federal Reserve makes interest rate changes.
If you are learning more about the Federal Reserve, check out these interesting facts from the Federal Reserve website: