How Do Central Banks Control Interest Rates?

Influencing interest rates is one of the most important things central banks do, because interest rates have a profound effect on economic growth, job creation and inflation. Low interest rates, for example, allow businesses to borrow money cheaply, which then enables them to expand and hire more people. For consumers, low rates enable people to borrow money to buy homes and big-ticket items such as automobiles, furniture, appliances, vacations and other items that boost economic growth.

Conversely, high interest rates have the opposite effect, discouraging businesses and consumers from buying and investing. But sometimes central banks need to raise rates in order to keep the economy from overheating, which could lead to inflation. That could eventually push prices higher and make goods and services too expensive, which could then cause businesses and consumers to stop or curtail their spending, leading to slower economic growth and eventually a recession.

The U.S. Federal Reserve, for example, tries to set interest rates at an optimum level—not too high, not too low—in order to achieve its congressional mandate of maximum employment, low and stable inflation, and moderate long-term interest rates. Other major central banks—such as the European Central Bank, the Bank of England, and the Bank of Japan—pretty much seek the same thing for their respective economies.[1]

They seek to influence interest rates outwardly through public pronouncements of their intentions, as well as through their dealings with banks and other important players in the financial markets in order to ensure that their intended policies become effective.

The Federal Funds Rate

In the U.S., the Federal Reserve's monetary policymaking unit, the Federal Open Market Committee, sets the federal funds rate. This is its benchmark interest rate, and also the interest rate banks pay to borrow and lend money to each other overnight that they hold on deposit at the Fed. This rate has a large effect on the general level of interest rates for businesses, consumers and governments throughout the economy, both short- and long-term.

In order to facilitate noncash payments such as through debit and credit cards, electronic transfers and checks that run through the economy each day, banks hold reserve balances at the Fed that they use to settle payments with each other. They also hold balances at the Fed "to meet unexpected liquidity needs" as well as to "satisfy a number of regulatory requirements aimed at ensuring that banks are sound and that their customers' deposits are safe."[2] Banks borrow and lend these reserves to each other as their needs arise. The rate at which they do this is the fed funds rate.

According to the Fed, changing the fed funds rate affects "overall financial conditions" throughout the economy, as that rate filters down to households, nonfinancial businesses and government entities.[2]

Effect On Long-Term Interest Rates

The fed funds rate also has an indirect, but important, effect on longer-term interest rates, because short-term rates create business and consumer expectations for the future. According to the Fed, "Fed communications about the likely course of short-term interest rates and the associated economic outlook, as well as changes in the FOMC's current target for the federal funds rate, can help guide those expectations, resulting in an easing or a tightening of financial conditions."[2]

During and after the global financial crisis, the Fed took a more direct—and unprecedented—step in trying to manipulate long-term interest rates, because the fed funds rate had already been reduced to zero without having the desired effect of boosting U.S. economic growth by giving borrowers and lenders the confidence they required. The Fed purchased trillions of dollars of U.S. Treasury securities and government-insured mortgage-backed bonds in order to try to drive down long-term interest rates in the overall market and to make financial conditions more accommodative. As of December 2018, the Fed is in the process of slowly winding down that portfolio.[2]

Open Market Operations

In addition to announcing its desired, or target, fed funds rate, the Fed also takes actions in the financial markets to ensure that its intentions are in fact carried out and that the fed funds rate stays within the range where the Fed wants it to be. It has three tools to conduct monetary policy: open market operations, the discount rate and reserve requirements. The FOMC is responsible for open market operations, while the Fed board of governors is responsible for the other two functions.

Open market operations (OMOs) include the purchase and sale of securities by the Fed in the open market. There are two types of OMOs: permanent and temporary.

Permanent OMOs involve outright purchases or sales of securities for the Fed's portfolio, such as what the Fed did during the financial crisis. Temporary OMOs are used to "address reserve needs that are deemed to be transitory in nature."[3] These operations are either:

  • Repurchase agreements (repos), which add temporary reserves to the financial system that should have the effect of lowering interest rates
  • Reverse repos, which temporarily drain reserves from the system, thus making borrowing more expensive.[3]

The Discount Rate And Reserve Requirements

The Fed can take other measures to control interest rates in the economy. In addition to the fed funds rate, the Fed sets the discount rate, which is the interest rate commercial banks and other depository institutions pay to borrow from the Fed's regional banks, which banks use as a backup source of liquidity. By lowering the discount rate, the Fed makes it cheaper to borrow, thus encouraging lending and spending by consumers and businesses. Raising the discount rate should have the opposite effect by making borrowing more expensive.

The Fed is also empowered to set banks' reserve requirements, which are the amount of deposits that banks must hold in cash, either in their vaults or on deposit at their regional Fed bank. By lowering the reserve requirements, banks have more money to make loans, while raising them has the reverse effect.[4]

Summary

One of the most important functions a central bank performs is influencing the level of interest rates, which has a profound effect on the overall economy. Low rates generally promote economic growth, while high rates usually stifle it. Central banks influence interest rates by both public pronouncements of their intentions while also buying and selling securities with major financial market players, such as commercial banks and other institutions.

While central banks generally have more control over short-term rates, their actions often influence long-term rates, too. During the global financial crisis, central banks also purchased massive amounts of long-term securities in order to try to drive down long-term rates.