The Fed has the power to control interest rates through government-backed securities. These investment instruments can be bought or sold, depending on what the Fed decides. If the central bank wants to lower interest rates, it buys a lot of securities, infusing the banking system with cash (kind of like in the old days when the Fed actually controlled the amount of money on the market). With more money available, interest rates decrease. If the Fed wants to raise interest rates, it sells securities. This adjusts the federal funds rate -- what banks charge one another for short-term loans. The Fed can also adjust the discount rate, which is the interest rate it charges banks for loans obtained directly from the Federal Reserve [source: FRB New York].
But why would the Fed want to change interest rates at all, let alone raise them? Because changing the interest rates can stimulate economic growth and fight inflation. It's trickier than it sounds.
There's a lag between the Fed's actions and recognizable results. And time is of the essence when quelling inflation or stimulating the economy, because opposite forces are at work. While taking action may have negative consequences, doing nothing can have a detrimental effect, too.
The average person is interested in real interest rates. "Real interest" is the difference between nominal interest (what's set by the Fed) and the rate inflation. Real interest rates are the ones you get from your bank when you purchase a car or take out a credit card. If it looks like inflation will go up in the future, real interest will be set at a higher rate.
But if the real interest rate is low, the costs of living, doing business and investing are also low. This stimulates the economy because home and car loans are more affordable. If people can borrow more, they'll spend more. Low real interest rates also generally weaken the dollar, which (in the short term) can be a good thing. When the dollar is weak, foreign goods are more expensive, so Americans tend to buy American-made goods. This stimulates the economy even further because high demand for American goods increases employment and wages [source: FRBSF].
So why doesn't the Fed simply keep nominal rates low? The problem is that this also leads to inflation. If a society's demands for a certain good exceed the supply, then the product's price will go up. When inflation increases, economic growth begins to slow. The price of the good increases, and so demand for it wanes. Less demand leads to less production, and eventually, unemployment ensues.
To offset inflation, the Fed must raise interest rates. Since low interest rates generally indicate a weak dollar, the increase in interest rates can strengthen the dollar. High interest rates can attract foreign investors looking for high-yield returns on their investments. This causes more demand for the dollar, which increases its value. Eventually, the increased value of the dollar will ultimately slow foreign investment, since it takes more foreign currency to purchase a dollar.
But the flow of investment can reverse. A stronger dollar has more buying power worldwide, which allows Americans to purchase foreign goods and invest in foreign companies. This puts added pressure on American companies to compete with cheaper foreign products. If the companies can't compete, unemployment rates rise and domestic economic growth decreases. Abroad, U.S. exporters' growth may slow, too, since a strong dollar increases prices for American-made goods abroad [source: FRB Chicago].
So there's a real method to the madness. To learn more about the Fed, interest rates and other related topics, follow the links on the next page.