How the Fed Raises Rates

Mike Mallak By | On September 15, 2015

You’ve likely heard over the past few years that the Federal Reserve is “going to raise rates”, but what does this mean?  The Federal Reserve, or just “the Fed”, occupies a strange space in the American economy.  As the banker’s bank it is an independent entity from the federal government but is still subject to oversight from Congress.  The Fed has many roles including issuing currency, selling and redeeming government securities, providing banking regulation and acting as a bank to the U.S. government and other banks.  This is all done with the goal of maintaining a stable banking system and a healthy U.S. economy.

The Fed has three main tools it uses to influence monetary policy:

  • Setting the Discount Rate – This is the interest rate at which the Fed will make short term loans to other banks.
  • Setting Reserve Requirements – This is the amount of money a bank must keep in reserves against the money a bank loans and invests.
  • Open Market Operations – This is the most important tool for the Fed. The Fed will buy or sell U.S. government securities in the open market to affect the price of credit (i.e. interest rates).  The goal of Open Market Operations is to influence the federal funds rate which is the interest rate banks borrow reserves from each other.

So, when you hear the Fed is going to raise rates it means the Fed is going to increase its target for the federal funds rate.  The fed will use open market operations to sell U.S. government securities in exchange for dollars, therefore reducing the money supply and influencing the federal funds rate higher.  A change in the federal funds rate has an impact on almost every other interest rate charged by U.S. banks.  When the Fed decides to raise its target for the federal funds rate, it’s reasonable to expect everything from mortgage rates to C.D. rates to credit card rates to increase over time.  In all this should slow economic growth.  If done correctly, the Fed can use its tools to keep the economy from swinging wildly from expansion to recession.

The Federal Open Markets Committee (FOMC) meets eight times each year to decide on a target for the federal funds rate and also the discount rate.  Each meeting is closely watched as the decision has a major impact on the economy.  The FOMC has held the federal funds rate at zero since the financial crisis.  This week marks another FOMC meeting so we will see if they are finally “going to raise rates”.