How The Fed Sets Interest Rates

These days, the economy is big news. The recession has affected many people directly, and they are looking for answers. As such, news stories about the economy are getting more attention than they once were. As the unemployment rate stays high and interest rates stay low, the nation keeps one eye on the Federal Reserve— the Fed—to see what they will do about it.

But how, exactly, does the Fed affect interest rates? And when it does, what does that mean for the average consumer? If references to the Fed and interest rates confuse you, here is a quick overview of the Fed and how its decisions affect your bottom line.

When people refer to the interest rates the Fed controls, they are usually talking about the Federal Funds Rate. This is the rate banks charge each other for overnight loans that are kept at the Federal Reserve. The Fed influences this interest rate using open market operations, in which it buys or sells government securities to banks. When the Fed sells securities, it takes money out of the banking system. However, when it buys them back, it puts money into the banking system.

The Fed’s actions at this point trickle down to affect the entire nation’s economy. When the Fed raises interest rates, banks raise interest rates on loans to compensate for their losses. This translates into higher interest rates for consumers who take out home, car or other loans. However, when the Fed lowers interest rates, banks can do the same. This saves consumers money and allows them to spend more, which helps the economy grow stronger.

With such far-reaching effects, interest rates aren’t controlled by just one person. There is a rather intricate process for changing interest rates. They are determined by the 12-member Federal Open Market Committee, or FOMC. Five members of this committee are Federal Reserve Bank presidents. The president of the Federal Reserve Bank of New York is a permanent member and the other four vacancies are filled by other presidents who serve on the committee for a year at a time on a rotating basis.

The FOMC meets every eight weeks to review materials and discuss policy options. Once they reach a consensus they give it to the president of the Federal Reserve Bank of New York, who is ultimately responsible for open market operations policies. If he or she implements the suggested changes, the interest rate will change. These changes usually only happen a quarter or half of a percent at a time.

The way we receive money into the United States banking system is complex, but it’s beneficial for average Americans to understand who the major players in the Federal Reserve are. These people hold at least some power to help strengthen the economy, and understanding the decisions they make can help you gain an understanding of what may be next in America’s financial future. 

Breanna Olaveson is a professional writer and editor and has been featured in various magazines, including Utah Valley BusinessQ, Utah Valley Magazine, Liahona, Ensign and MainStreet. She has a B.S. in communications and continues to write about business, entrepreneurship, marketing, success, lifestyle and more. Breanna is currently working with Professional Marketing International helping entrepreneurs reach their goals.