Debra R. Lins, MBA
Lins Business Consulting LLC - White Paper
How Does the Fed Set Rates
Many times there is a lack of understanding or awareness as to how the Federal Reserve System (Fed) "sets" interest rates. It is important
to note, the same principles apply to a bank's rates for both deposits and loans. Perhaps this quick overview will assist in explaining
interest rate changes.
Let's start with the Fed. The Federal Reserve does not actually "set" or "change" interest rates; they only alter the conditions in the
market that influence interest rates. The reasons for pursuing to change interest rates are for the purpose of exerting control on the
overall economy. Generally, lower rates are desirable to spur economic activity; whereas higher rates are employed to cool off (slow down)
the economy and to control inflation.
Interest rates are largely influenced by the law of supply and demand - when the supply of money to lend exceeds the demand for loans,
the price of a loan (reflected in the interest rate) declines. The reverse is also true - when the demand for loans exceeds the supply
of lendable funds, the price (reflected in the interest rate) goes up. The Fed influences those dynamics by buying or selling U.S. Treasury
Securities, which can raise or lower the supply of money in the private sector. For instance, when the Federal Reserve wants higher rates
in order to control inflationary factors it will sell securities, this in turn reduces the amount of "money" in circulation. "Money" is
defined as predominantly currency and demand deposits in all banks.
Financial institutions do not directly influence overall rate changes. These institutions instead react to a rate change. Correspondingly,
as the supply of money decreases banks and credit unions may raise the rates paid on customers' deposits to attract new deposits and to
retain existing dollars already on deposit. Similarly, a financial institution raises the rates charged for loans in order to meet the
added cost on deposits. How fast a financial institution responds in making changes to their rates depends on the underlying supply and
demand factor discussed, and how fast their competition changes interest rates.
I hope you have found this high level summation of how the Federal Reserve influences interest rates of merit.