On December 16, the Federal Reserve announced that they’d be making adjustments to their efforts to help the economy. Fed Chairman Jerome Powell announced that they [(he Federal Reserve) would continually deliver support for the economy until its recovery.
The U.S. Federal Reserve is the country’s central banking system that promotes price stability and full employment. Simply put, the Fed is responsible for controlling the supply of money circulating throughout the country and enforcing their strict monetary policy.
How the Fed manipulates interest rates
Along with other central banks in different countries, the Fed both raises/lowers interest rates to agitate the economy and control/delay inflation. They conduct this through their Federal Open Market Committee.
The Fed partakes in the open market operations that buy or sell treasury notes from banks. When the Fed takes securities from banks, they add credit to the bank’s reserve. More credit added to the bank is akin to having cash added to their reserve. If the Fed wishes to raise rates, the Fed will have to add securities to the bank and take credits away from banks, forcing the bank to borrow fed funds to ensure they have enough.
The echo effect: how this causes interest rates to soar or dip
These effects are trickled down to the bank’s customers. When the Fed increases its federal funds’ rate, borrowing becomes more costly for banks. These banks, in turn, pass the higher rates to the customers.
As we have all experienced, banks charge customers with interest rates. It’s also the same for banks giving other banks loans. They incur interests, too, which is called the Fed funds rate. The Fed funds, or the money that banks loan to other banks, are used by banks to meet the reserve requirement when they don’t have enough money. The Fed requires banks to have reserve money every night. Without this, the bank might lend all the money they have.
These reserve requirements change depending on what the Fed sees fit. When the Fed raises the reserve requirement, it reduces money that banks can lend and can loan out. When the supply of money is lower, banks can now charge more to lend to other banks and people. Thus, interest rises.
How we can hear the echo from afar
When the Fed funds rate is higher, interest rates also rise. Namely:
- Increase in interest rates being paid to customers’ saving accounts and money market deposits.
- The prime rates, which are interest rates that U.S. banks use to charge select customers, are also changed. This affects most customers because banks use prime rates based on credit-card rates, adjustable-rate loans, and interest-only mortgage loans. For example, when prime rates are high, variable credit card rates are higher too. This means you may pay more credit card interest rates in months with high prime rates.
- The London Interbank Offered Rate, or LIBOR, is also dependent on Fed funds rates. LIBOR is another benchmark that the bank uses to know what interest rate they should charge for overnight, three-month, six-month, and one-year loans. If your loan is an adjustable-rate loan, your rate will depend on the LIBOR rate. Thus, if LIBOR rises, your monthly payment will increase too. Even if your existing loans are fixed-rate loans and your credit card debt is paid off every month, LIBOR still makes all loans expensive, which in turn reduces consumer demand.
- Higher Fed funds also drive Treasury yields higher, which will make fixed-rate mortgages and loans higher. Even though they aren’t directly connected, it’s still indirectly influenced.
Buying bonds and keeping rates low are the Fed’s best arsenal to help the economy return to normal. The Federal Reserve also promised to keep its policy accommodating to all Americans until the economy gets back to its feet again. The Fed will only raise the Fed funds rate again once they have deemed it safe to do so. And if they do, they’ll give plenty of notice before changing anything.