Why does the Fed change the interest rate?

The U.S. Federal Reserve building in Washington, D.C. See more images of Washington, D.C.
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You hear about it a few times a year: The Fed has raised interest rates, or the Fed delivered an interest rate cut after its latest meeting. Excited, you go to your local bank to check out its brand-new rates on car loans. To your disappointment, they're the same as they were yesterday. What gives?

The Fed, formally known as the Federal Reserve Bank, does have a tremendous amount of power. It can just take awhile to trickle down -- which would explain your disappointment over your bank's rates.

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The Federal Reserve Bank is a group of interrelated private corporations, independent from (but entirely enmeshed in) the U.S. government, that controls the movement of money throughout American finance. The Fed actually used to control the amount of money available to circulate. But these days, it has the same effect without having to turn the money spigot on and off. Economists still keep an eye on the amount of money in circulation, called money aggregates. This refers to where Americans are keeping their money.

The aggregates most closely watched are in the form of things like currency and checking accounts, as well as savings accounts and mutual funds. Economists use these as a measuring stick when they make decisions regarding monetary policy [source: FRBSF]. These are the places where money can be most easily spent -- it's easier to write a check than it is to cash a bond. In 2002, the use of this indicator was discontinued as a tool for making sweeping economic decisions.

This makes life for Fed Chairman Ben Bernanke even more difficult. Bernanke's job is among the most stressful in the world. To be a Fed chairman, one must be an "oracle" [source: CNN Money]. Bernanke is responsible for the economic health of Americans -- from the assembly line worker to the major investment banker. With so much at stake, why would the Federal Reserve bother changing anything at all?

Read about the delicate nature of interest rate adjustments on the next page.

The Effects of Changing Interest Rates

Federal Reserve Chairman Ben Bernanke in Frankfurt, Germany, in November 2006.
Federal Reserve Chairman Ben Bernanke in Frankfurt, Germany, in November 2006.
Bernd Kammerer/AFP/Getty Images

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.

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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.

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Sources

  • Isidore, Chris. "Why the Fed can't put out the fire." CNN Money. March 18, 2008. http://money.cnn.com/2008/03/17/news/economy/fed_response/index.htm?postversion=2008031809
  • Sivy, Michael. "The Fed chairman takes a bullish stand." CNN Money. July 19, 2005. http://money.cnn.com/2005/07/19/pf/sivy_greenspan_0508/
  • "How does monetary policy affect the economy." Federal Reserve Bank of San Francisco. http://www.frbsf.org/publications/federalreserve/monetary/affect.html
  • "The Fed's role." The Federal Reserve Bank. http://www.newyorkfed.org/education/role.html
  • "Strong dollar, weak dollar: Foreign exchange rates and the U.S. economy." Federal Reserve Bank of Chicago. http://www.chicagofed.org/consumer_information/strong_dollar_weak_dollar.cfm
  • "How does the Fed determine interest rates to control the money supply?" Federal Reserve Bank of San Francisco. February 2005. http://www.frbsf.org/education/activities/drecon/answerxml.cfmselectedurl=/2005/0502.html