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How Does the Fed Lower Interest Rates?



Federal Reserve Chair Janet Yellen carefully considers the economic indicators before changing the Fed funds rate.

Photo: Alex Wong/Getty Images
Fed chairs

(L-R) Federal Reserve Chairs Janet Yellen, Paul Volker, Alan Greenspan and Ben Bernanke used the Fed funds rates to varying degrees.

Photo: Mark Wilson/Getty Images

Question: How Does the Fed Lower Interest Rates?

Answer: The Federal Reserve cuts the Federal funds rate through its regularly scheduled Federal Open Market Committee (FOMC). The FOMC sets a target for the Fed funds rate after reviewing current economic data. This interest rate is charged by banks who lend Fed funds to each other. All banks must meet the Federal reserve requirements each night. If they don't have enough reserves, they will borrow the Fed funds needed to do so.

Technically, the Fed funds rate is set by the banks themselves, not the Federal Reserve. However, the Fed can use its open market operations to put pressure on the banks to raise and lower the rate. The Fed simply purchases assets from the banks (usually Treasury notes) and places a credit on the bank's reserve account. Now the bank has reserves it doesn't need to meet its requirement. Therefore, it's willing to lower its Fed funds rate to lend the extra reserves to other banks. For the most part, the Fed funds rate rarely varies from the target rate.

However, the Fed has other tools it uses to reinforce the Fed funds rate. It can change the discount rate, which is what it charges banks who borrow directly from its discount window. These are some of the tools the Fed used to restore liquidity in the 2007 Banking Crisis.

The Fed funds rate is used by banks to set their other short-term interest rates. They charge a bit more for LIBOR, which is what they charge each other for one-month, three-month, six-month and one-year loans. It's also a base for the prime rate they charge their best customers. Banks use the Fed funds rate as a base to determine the interest rates they pay on NOW checking accounts, CDs and savings accounts. It also guides the higher interest rates they charge for bank loans, credit cards, and adjustable-rate mortgages. Article updated February 21, 2014

A Reader Asks:

I was wondering why articles say that the Federal Reserve cuts the Federal fund rates. I try to bring it up in discussions in my economics class but others say that the federal reserve doesn't cut the federal funds rate. I understand that the Fed, through the FOMC, can cut the Federal funds rate. I guess my question is how exactly does the Federal Reserve "influence" the FOMC to cut the Federal funds rate. This came to my concern when I was reading this article: A Primer on Current Federal Reserve Interest Rates. Thanks for your time.

The FOMC (Federal Open Market Committee) is the monetary policy arm of the Federal Reserve Banking System. The FOMC Committee is made up of the Fed Chairman, its Governing Board and representatives of the member banks. In other words, the Fed doesn't have to influence the FOMC because it is the FOMC. However, the FOMC member have to convince each other to agree on a policy.

The FOMC sets a target for the Fed funds rate at its regular meeting. This Federal interest rate is charged for Fed funds, which are loans made by banks to each other to meet the Fed reserve requirement. Technically, these rates are set by the banks themselves, not the Federal Reserve or the FOMC

However, for the most part, these rates rarely vary from the target rate. This is because the Fed uses its open market operations to put pressure on the Fed funds rate to meet its target. Here's how it works. In open market operations, the Fed buys or sells securities (Treasury notes or mortgage-backed securities) from its member banks. In return, it adds a credit to the banks reserves. The banks wants loan any extra reserves to other banks who need them to meet the requirement. Banks will make sure the interest rate (the Fed funds rate) is as low as possible to get rid of excess reserves.

Update: In late 2008, the Fed greatly expanded its open market operations. For more, see What Is Quantitative Easing?. It also dropped the Fed funds rate to zero. For more, see Current Fed Funds Rate.

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