The Power of the Fed Explained
by Sarah Bush | By now, most nightly news watchers know that the Federal Reserve raised interest rates last Tuesday. As usual, the Fed's decision was met with much fanfare. In the weeks leading up to the Fed meeting, every market commentator worth his or her salt put forth a bet on the action. In the hours preceding the November 16, 1999, announcement, CNBC even ran a countdown to the decision.
But what exactly does it mean when the Fed raises interest rates?
Interest Rates
The phrase itself is more than somewhat misleading. Saying that the Fed raises or lowers interest rates makes it sound as if there is one single interest rate.
Instead, there are any number of interest rates. There's the interest rate you pay when you take out a mortgage and the interest rate your bank pays you on your savings account. The income paid by a bond is yet another form of interest rate.
These interest rates--or in the case of bonds, yields--depend on a variety of factors. How much interest is a borrower willing to pay in order to have the use of a dollar today? What does a lender demand to compensate for the risks associated with lending money? The chance that the loan won't be repaid is one such risk. Inflation is another: The real value of a dollar in several years could be a lot less than it is today. Thus, an investor would probably demand a higher interest rate in an inflationary environment. These risks increase with time, so longer-term bonds and loans typically carry higher rates.
Most commonly cited in the financial press are rates on bonds with no credit risk. Money-market rates are at the short-term end of this spectrum; the 30-year Treasury rate is the most commonly cited of long-term interest rates.
The Fed's Role
The Federal Reserve is charged with formulating and exercising monetary policy, and a big part of that is maintaining interest rates at a level that allows for controlled economic growth. Interest rates are important because they help determine the ease and cost with which people and businesses can borrow money. In theory, low rates (and ample money supply) stimulate economic growth; high interest rates slow the economy. Growth isn't the only concern, however. If the economy grows too fast, scarcity of labor and other resources can drive up prices and spur inflation. The Fed's goal is to achieve some balance.
Obviously, however, the Federal Reserve doesn't run around trying to set all the different interest rates individually, telling car dealers how much to charge for their loans and dictating what yields corporations should offer for their bonds. Instead, the Fed has several less direct ways of influencing interest rates, the most important of which is its ability to move the federal-funds rate.
Federal funds are reserves held by the Federal Reserve System that can be transferred between banks. By law, banks and other depository institutions must keep a certain percentage of their deposits in cash or on reserve at the Fed. However, banks with more reserves than they need can lend to other banks to help them meet these requirements and clear financial transactions. These funds are called federal funds, and the fed-funds rate is the interest rate banks charge each other for these short-term loans.
The Fed can manage the fed-funds rate by buying and selling government securities.
To understand why, remember that interest rates are ultimately set by market forces, the balance of supply and demand for money. Think of interest rates as the cost of borrowing money. The relationship between supply and demand works just as explained in most Econ 101 classes. An increase in money supply lowers the cost of borrowing money. A decrease in supply raises the cost of borrowing money.
The Fed acts on the supply side of this equation. When the Fed buys government securities, it infuses money into the banking system, and the cost of borrowing money--measured by interest rates--falls. On the flip side, when the Fed sells government securities, money flows from banks into Fed coffers, and there's less money to go around. Less supply means a higher cost of borrowing, and the fed-funds rate rises.
This process is commonly referred to as the Fed's open-market operations. When the Federal Open Market Committee, the Federal Reserve's top monetary policymaking body, meets, it sets a target for the fed-funds rate.
But why is the fed-funds rate so important? Changes in the cost of borrowing between banks typically have a big impact on short-term interest rates. If a bank is paying high rates to borrow money, it will charge more to lend money. And although short-term interest rates are the rates most directly affected by changes in Fed policy, long-term rates are not independent. Changes in short-term rates can dramatically effect the yields on longer-term bonds.
The Fed has several other tools available to it. For one, the Fed can tinker with the percentage of their deposits a bank must hold on reserve, but because this tool is considered to be imprecise, it is seldom used. Additionally, the Fed can change the discount rate, the rate at which the Federal Reserve makes short-term loans to banks. As part of the Fed action last Tuesday, this rate was raised as well.
Of course, the Fed's decision to raise or lower interest rates is not the only force acting on the bond markets. Many of the same factors that drive the Fed's decision act independently on the bond markets. As mentioned earlier, the risk of inflation can drive rates higher (bad news for bond prices, which move inversely to yields). Additionally, interest rates in this country are often influenced by factors overseas. Last year, for example, when global equity markets took a tumble, supersafe Treasury bonds were the hottest things going. An onslaught of demand for these bonds drove their yields lower and lower, long before the Fed reduced interest rates.
Any way you cut it, the Fed is a pretty powerful force. Just the anticipation of Fed action often moves rates, which explains why the bond markets hang on Alan Greenspan's every word. |
