The Federal Reserve and Interest Rates

The Federal Reserve and Interest Rates
16 Jul 2019

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Reasonable interest rates are the cornerstone of banking and the economy. Without interest, there would be no incentive to loan money or save in banks. Over the centuries, borrowing has become more sophisticated and complex. A single percentage point can influence billions of dollars in commerce.

The government is aware of just how critical borrowing is to our economy and put the U.S. Federal Reserve in charge of influencing market interest rates. It knows that by changing rates, it can help America avoid dips in the economy and even jumpstart it out of a depression.

What Interest Rates Mean for the Economy

The growth of the economy is based largely on how cheap it is to borrow money. The lower the interest rates on a loan, the cheaper it is for people and businesses to borrow money for expansion and large purchases. If a bank charged 30 percent interest on a loan, individuals would not be able to afford mortgages for houses and only a few startup businesses would be funded. However, if banks issued loans at 1 percent, people would be willing to try riskier business ventures and spend more money on their homes.

Though there are an incalculable number of factors at work in an economy, the average interest rate is among the most influential. When the economy needs help, the government looks to the Federal Reserve to change its policies and adjust interest rates.

The Federal Reserve

The Federal Reserve, informally referred to as “the Fed,” was established in 1913 and consists of 12 regional reserve banks spread throughout the country. Aside

from regulating bank deposits, the Fed also determines the country’s monetary policy.

The Fed requires all commercial banks to hold a certain percentage of all their accounts value in cash at their regional federal reserve bank. This prevents banks from loaning out too much money and not being able to pay for customers withdrawing cash or closing accounts.

The Federal Funds Rate

Banks do not like to keep extra money lying around; cash kept with the Fed could be loaned out and earning interest. As a result, a bank will try to keep as little money on account with the Fed as possible. However, if the bank has a busy day, it may suddenly find it needs more money in its federal deposit to meet Fed regulations.

Fortunately, when a bank needs a larger deposit at the Fed, it can ask to borrow the extra money from another bank that has a surplus in its Fed account (typically the loan just lasts overnight).

The federal funds rate is simply the target loan rate the Fed would like to see banks using when borrowing with each other.

Changing the Rate

Since the Fed cannot enforce the rate private banks loan money at, it will change in the public money supply until the market determines a rate close to the target rate.

How? When the Fed sets a lower target funds rate, it buys U.S. Treasuries from the public. This increases the money in circulation, much of which gets deposited into commercial banks by individuals. With more cash on hand at banks, the number of banks with surpluses increases and the demand for overnight loans drops. With more surplus accounts, banks still needing loans can negotiate a lower rate. The Fed continues to add money until the actual loan rate matches the target.

Correspondingly, when the target rate is raised, the Fed will sell U.S. Treasuries (or other securities) and remove money from circulation. This creates higher demand for overnight loans and causes banks to raise their actual loans rates.

Just as increases or decreases in money supply cause banks to loan each other money at different rates, they also change the rate at which the banks will make loans to people. The easier it is for a bank to get money, the more willing it is to loan it out to the public.

The Federal Discount Rate

In addition to borrowing money from one another, banks are allowed to borrow money directly from the Fed (often called “using the Fed window.”) The rate at which the Fed loans out money is called the federal discount rate. This rate is often used synonymously with the federal funds rate, but they are not the same. The federal discount rate is typically between 0.25-1.00 percent higher than the federal funds target rate. The discount rate and Fed window ensures that banks always have a source of loans and prevents banks from charging each other too much.

Goals of Adjusting the Federal Funds Rate

The main purpose of increasing or decreasing the federal funds rate is to control how easy it is for the public to get loans. Cheap loans encourage businesses to expand and people to buy long-term goods like houses and cars. Easy access to loans gets more money flowing in the economy and puts more people to work.

During times of economic contraction or under-performance, the Fed’s first step will usually be to lower the funds rate. The hope is that cheaper money will encourage people to spend more money and stimulate the economy before too many jobs are lost.

When the economy is severely depressed, low rates help start-up businesses get cheap loans and create new jobs. Low loan rates also translate to low incentives for saving, encouraging individuals to put their money to work by investing in companies.

Raising the rates is also a necessary function. After an economy has recovered, it can become overheated if rates stay low and money is too easy to get. When too much money is passed around too quickly, inflation climbs significantly. By raising rates and withdrawing money from the market, the Fed can slow things down and keep prices from getting out of hand.

Though the manipulation of interest rates has its critics and seems unnatural in a free market, the Fed’s goal for the federal funds rate is always to support a smooth economy and keep people employed. Since the productivity of American workers is what gives the dollar its value, keeping the economy strong is key to our international wealth.

Future Changes

The future of the federal funds rate remains unclear. The Fed has never needed to keep interest rates as low as they have been in recent years. Though the federal funds rate can be increased if we need it to combat inflation, no one is certain what impact repeated interest rates hikes will have on the economy.

Eventually, the target rate will be raised to normal levels for one reason or another; hopefully, because low rates are no longer needed. As the economy changes, the Fed may create new regulations and strategies, but it will always adjust its plans to promote prosperity.

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This article was written by Advicent Solutions, an entity unrelated to Premier Investments of Iowa, Inc.. The information contained in this article is not intended to be tax, investment, or legal advice, and it may not be relied on for the purpose of avoiding any tax penalties. Premier Investments of Iowa, Inc. does not provide tax or legal advice. You are encouraged to consult with your tax advisor or attorney regarding specific tax issues. ©2013, 2016 Advicent Solutions. All rights reserved.