How The Federal Reserve Sets Interest Rates

Interest rates can determine if your business sinks or swims. Here's how the Federal Reserve determines them.
President, Proximo, LLC
July 14, 2011

Almost every person, company and government entity in the U.S. owes money to someone. According to the Federal Reserve, we currently owe—in aggregate—nearly $55 trillion. Just like consumers and governments, businesses use debt to finance day-to-day expenses and long-term investments. Non-financial business debt represents approximately $11 trillion of this total.

This massive level of borrowing costs businesses billions of dollars in interest payments per month. It should therefore come as no surprise that interest rates play a critical role in the success or failure of businesses. As interest rates increase, companies have less money available for more productive uses like hiring and investing. If they increase suddenly, it may even lead to business failure.

Interest rates are not set by the laws of supply and demand. Each bank that has money to lend doesn’t independently set rates based on what the market will bear. At their core, the interest rates that we pay on borrowed money for our businesses are set by the Federal Reserve.

The U.S. Federal Reserve System and money supply

The U.S. Federal Reserve System (“the Fed”) is the Central Bank of the United States. Like most Central Banks, the Fed has many duties including conducting monetary policy and regulating banks. “Monetary policy” means controlling the supply of money. The goal of the Fed’s monetary policy is to keep inflation under control and keep unemployment low. When it appears that inflation is increasing, the Fed works to contract the money supply to cut off inflation. When it appears that the economy is losing steam and unemployment is going up, the Fed expands the supply of money to incentivize companies to invest and consumers to spend.

This control of the money supply doesn’t happen through a magical amulet in Ben Bernanke’s pocket; instead it happens mainly through interest rates. By manipulating interest rates, the Fed exerts control over the money supply to achieve its intended purposes. It doesn’t always work as planned, given the scale and complexity of our economy, but for the most part it has proven effective.

So how does the Fed manipulate interest rates?

The Fed has several tools at its disposal. The main tool it uses is the setting of the Target Federal Funds Rate.

Recall that the regulation of banks is among the Fed’s duties. In order to ensure that banks maintain a safety margin on their lending activities, the Fed requires them to keep a certain amount of capital on deposit with a Federal Reserve Bank. These deposits are known as “Federal Funds.” This amount varies based on the bank’s loans outstanding (its assets) and its deposits (liabilities) every day. As a result, on any given day some banks may have excess capital on deposit at the Fed, and other banks may fall a little short. The Fed permits banks that have excess reserves on deposit to loan them to other banks that are falling short through “overnight” loans. The interest rate at which these loans are made is called the “Federal Funds Rate.”

The Fed doesn’t set a specific Federal Funds Rate. These rates are negotiated between the lending bank and the borrowing bank. But the Fed does let their opinion be known by setting a target rate which is usually given as a range. The current Target Federal Funds rate is 0-0.25 percent. If the rates banks are negotiating fall outside the target range, then the Fed takes steps—known as “open market operations”—to bring the rates into line with their target.

The Federal Funds Rate could be considered the foundation of all interest rates. Changes to the Target Federal Funds Rate pass through to business and consumer loans—there is a lag of up to a year or more as the change works its way through the system. So when the Fed makes a change to the Target Federal Funds rate, they are really making an educated guess as to where interest rates in the economy need to be a year from now.

It’s no easy task.

President, Proximo, LLC