So, how does the Federal Reserve affect interest rates?

The Fed, made up of 12 Board of Governors who are Presidential appointees with 14 year terms, affects banks’ interest rates indirectly.

They indirectly affect the interest rates in three ways:

First, the most influential thing the members of the Fed do is referred to as open market operations. This means they sell or buy government securities, also known as Treasury securities, on the open market. If they want to shrink the national money supply, they sell securities (who are the typical buyers, I wonder.) And, if they want to increase the national money supply, they buy securities (from whom, I wonder, and with what money –money is transferred from where to where? How does the buying and selling of these securities affect the national money supply?)

These securities transactions directly influence the amount of reserve funds that commercial banks have to lend each other. (How do these security transactions affect the reserve funds of commercial banks?) The open market purchase of securities, for instance, increases the amount of money that banks have available to lend. The amount of money a bank has to lend affects what’s known as the banks’ federal funds rate. The federal funds rate is the rate banks charge each other for overnight loans. The federal funds rate falls if the banks have lots of money to lend each other, and rises if banks have little money to lend each other. (Why do the banks lend money to each other “overnight”? Is this a big part of banking?)

So far, it seems that the Fed’s selling or purchasing of Treasury securities affects the federal fund rate, but then how does this affect interest rates?

A member of the Federal Reserve Board of Governors, named Laurence H. Meyer, explains:

“While the federal funds rate itself is not a particularly important influence on the economy, movements in the federal funds rate (and expectations about future federal funds rate encouraged by any change) influence the broad spectrum of interest rates and financial asset prices in the economy. In this way, changes in the federal funds rate exercise an important influence on the demand for goods and services, especially those that are relatively interest-sensitive.”

I still don’t know exactly how the federal funds rate influences interest rates, but it must be because the amount of money a bank has influences the amount of interest it needs to charge on loans.

(Incidentally, the open markeet operations are decided eight times a year by a committee called the Federal Open Market Committee (FOMC.) After each meeting, the FOMC reports to the news media the targeted federal funds rate, the inter-bank lending rate the Fed hopes will be achieved with the securities they have sold or purchased. The media usually mislabels this as a change in the interest rate.)

A second way that the Fed can influence the interest rates in banks is by altering something called the discount rate. This is the rate of interest on the money the Fed is willing to lend commercial banks. The discount rate is usually adjusted in relation to the open market operations. Commercial banks sometimes need to borrow money from the Fed, because of unanticipated shortages or demands.

Finally, the Board of Governors can influence interest rates by manipulating the reserve ratio –the amount of money the banks are required to have on hand. As mentioned in a previous blog entry, the Fed doesn’t change this often. They last changed this ratio in 1992.

Later, I’ll try to explain why the Fed does all this manipulating of securities and federal funds rates. It’s part of its larger goal to create a “healthy economy,” one that is growing and employs many people.