The Fed doesn’t actually control its key interest rate. Here’s what does | CNN Business (2024)

The Fed doesn’t actually control its key interest rate. Here’s what does | CNN Business (1)

Thought the Federal Reserve was in charge of interest rates? Think again.

Washington, DC CNN

The Federal Reserve has a lot of sway over the US economy and financial markets. But there’s one thing it doesn’t have: the ability to get interest rates to the exact level it wants.

How could that be? Doesn’t the Federal Reserve control interest rates?

Actually, no, it doesn’t.

While you may have read that Fed officials voted to raise, lower or hold interest rates steady after their monetary policy meeting, what they’ve actually voted on is the target range for the federal funds rate.

That range determines the actions the central bank will take behind the scenes through the use of its multitrillion-dollar balance sheet to influence borrowing costs across the economy on everything from mortgages to commercial loans.

Here’s how that all works:

An overview of monetary policy

Monetary policy is meant to either restrict or stimulate the economy, depending on whether inflation is too high or employment is too low. The Fed has been trying to slow the economy to combat high inflation for about a year and a half now through a series of rate hikes.

The Fed’s main tool — the federal funds rate — is the interest rate that commercial banks charge each other when lending excess bank reserves, which are cash minimums a financial institution is required to have on hand and is calculated as a certain percentage of a bank’s total deposits.

The Fed’s benchmark lending rate is currently at a range of 5.25-5.5%, the highest in 22 years.

Bank reserves, parked at the Fed or stored in a bank’s own vaults, are required to meet depositors’ needs in case of unexpected demand for withdrawals, and can be easily converted into cash. Banks lend each other these reserves because it is a quick way to move cash from one bank to another.

For example, if a bank in California wants to transfer money to a bank in Florida, the California bank can easily instruct the Fed to move reserves from its account at the central bank to the account of the Florida bank and, voilà, the money is quickly transferred overnight and made available to the bank.

How exactly does the Fed move the target range?

The Fed pays interest on bank reserves. That rate, which is determined by the Fed’s Board of Governors, helps the central bank carry out its desired target range because it puts a floor on the interest rate banks will be willing to accept to lend to other banks.

For instance, if the Fed pays more interest on bank reserves it means banks can earn more money from holding on to funds as opposed to lending them out. Therefore, the banks will demand higher interest rates to lend to one another. That then means banks will have to charge higher interest rates on loans they make to consumers and businesses.

The Fed gets the money to pay banks interest on reserves by trading mainly Treasuries and mortgage-backed securities.

To reduce the supply of bank reserves, the Fed sells the Treasury securities in its portfolio, causing bank reserves in the banking system to decline equally, former Fed Chair Ben Bernanke explained in a book published last year.

“With fewer reserves available, the rate (price) that banks paid to borrow reserves from each other naturally rose, as intended by the (Fed),” he said.

And to lower the funds rate, the Fed does the opposite: The Fed gobbles up Treasuries, increasing the supply of bank reserves in the system, thus lowering the central bank’s benchmark lending rate.

After raising the funds rate 11 times since March 2022, the Fed has made significant progress in slowing decades-high inflation, which erupted in 2021 as a result of pandemic-driven demand and supply shocks.

Still, inflation remains well above the Fed’s 2% target, and the central bank will continue to utilize its tried-and-true policy tool until the job is done. Investors are expecting rate cuts as soon as next year’s first quarter.

The Fed is holding its last two-day monetary policy meeting of the year this week, with an announcement on rates due Wednesday at 2pm ET, followed by a press conference from Fed Chair Jerome Powell.

—CNN’s Elisabeth Buchwald contributed to this report.

The Fed doesn’t actually control its key interest rate. Here’s what does | CNN Business (2024)


The Fed doesn’t actually control its key interest rate. Here’s what does | CNN Business? ›

The Fed doesn't actually control its key interest rate. Here's what does. The Federal Reserve has a lot of sway over the US economy and financial markets. But there's one thing it doesn't have: the ability to get interest rates to the exact level it wants.

Does the Fed control interest rates what do they control? ›

The Fed sets target interest rates at which banks lend to each other overnight in order to maintain reserve requirements—this is known as the fed funds rate. The Fed also sets the discount rate, the interest rate at which banks can borrow directly from the central bank.

How does the Fed affect businesses? ›

The Federal Reserve's decisions on interest rates significantly impact the economy, affecting everything from the costs consumers and businesses pay to borrow money to the job market, the stock market and inflation.

What happens when the Fed reduces interest rates? ›

Lower interest rates would reduce borrowing costs for homes, cars and other major purchases and probably fuel higher stock prices, all of which could help accelerate growth.

What happens to our economy when the feds raise interest rates? ›

How does raising interest rates help inflation? The Fed raises interest rates to slow the amount of money circulating through the economy and drive down aggregate demand. With higher interest rates, there will be lower demand for goods and services, and the prices for those goods and services should fall.

Who really controls interest rates? ›

Interest rates are determined, in large part, by central banks who actively commit to maintaining a target interest rate.

Who is controlling interest rates? ›

The Federal Reserve's Federal Open Market Committee (FOMC) sets a target interest rate policy for the federal funds rate. This is the rate at which commercial banks borrow and lend excess reserves to other banks on an overnight basis.

How does the Fed funds rate affect business? ›

When interest rates are rising, both businesses and consumers will cut back on spending. This will cause earnings to fall and stock prices to drop. On the other hand, when interest rates have fallen significantly, consumers and businesses will increase spending, causing stock prices to rise.

Who benefits from higher interest rates? ›

As interest rates rise, the interest income from loans typically increases faster than the interest paid on deposits, leading to wider profit margins. Additionally, higher interest rates can boost the earnings of insurance companies and investment firms, as they often hold large portfolios of interest-sensitive assets.

How does the Fed's use of interest rates affect the business cycle? ›

Moreover, as borrowing increases, the total supply of money in the economy increases. So the end result of lowering interest rates is fewer savings, more money supply, more spending, and higher overall economic activity – a good side effect. On the other hand, lowering interest rates also tend to increase inflation.

What sectors benefit from low interest rates? ›

The consumer discretionary, technology, real estate, and financial sectors have historically been especially likely to outperform the market when rates fall and earnings rise. Financial stocks look particularly appealing, due to how inexpensive they've recently been.

Why is the Fed not cutting interest rates? ›

The Fed is determined not to reduce interest rates too soon, experts say — a mistake the central bank has made in the past. Since the start of 2024, higher-than-expected inflation data triggered caution from top Federal Reserve officials.

Do banks make more money when interest rates rise? ›

A rise in interest rates automatically boosts a bank's earnings. It increases the amount of money that the bank earns by lending out its cash on hand at short-term interest rates.

What are the disadvantages of increasing interest rates? ›

Higher interest rates typically slow down the economy since it costs more for consumers and businesses to borrow money. But while higher interest rates can make it more expensive to borrow and could hamper overall economic growth, there are also some benefits.

What are the cons of the Federal Reserve? ›

Cons of the Federal Reserve

The Federal Reserve operates independently of the U.S. government, and its monetary policy decisions are not approved by Congress or the U.S. president. This independence helps the Fed operate free of political pressure, but it also limits the Fed's accountability.

Why do the feds keep raising rates? ›

To push unemployment down, the Fed runs wide-open, lowering interest rates and creating money. But to moderate inflation, the Fed does the opposite, raising interest rates and reducing the money supply.

What can the Fed control? ›

The Federal Reserve controls the three tools of monetary policy--open market operations, the discount rate, and reserve requirements.

What are the three major functions of the Federal Reserve? ›

It is the Federal Reserve's actions, as a central bank, to achieve three goals specified by Congress: maximum employment, stable prices, and moderate long-term interest rates in the United States (figure 3.1).

What does the Fed use to control the economy? ›

The Federal Reserve, America's central bank, is responsible for conducting monetary policy and controlling the money supply. The primary tools that the Fed uses are interest rate setting and open market operations (OMO).

What does the central bank interest rate do? ›

A bank rate is the interest rate a nation's central bank charges other domestic banks to borrow funds. Nations change their bank rates to expand or constrict a nation's money supply in response to economic changes.


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