Tag: inflation

Part 2: How does the Federal Reserve manipulate interest rates?

Welcome back! To start off blunt, the Federal Reserve answers this question on its website. They state,

“When necessary, the Fed changes the stance of monetary policy primarily by raising or lowering its target range for the federal funds rate, an interest rate for overnight borrowing by banks. Lowering that target range represents an “easing” of monetary policy because it is accompanied by lower short-term interest rates in financial markets and a loosening in broader financial conditions. This action may be needed if the economy is sluggish or inflation is too low. Raising the target range represents a “tightening” of monetary policy, which raises interest rates and may be necessary if the economy is overheating or inflation is too high.”

Great. Here we introduce what’s called the Federal Funds Rate (FFR), the interest rate for overnight borrowing by banks. This is a range of possible interest rates at which banks charge for taking 1-day loans from each other. Banks hold ‘reserves’ at the Fed and get paid a certain amount of interest on these reserves, coined the Interest on Reserve Balances (IORB). The IORB is the Fed’s primary tool for guiding the federal funds rate. So, the Fed sets the IORB which influences the FFR. Boom. The Fed created the 1-day interest rate.

Crucially, the Fed doesn’t need to do much to ‘give’ private banks reserves. In fact, the Fed creates reserves electronically out of thin air. They create these reserves and create the money they use to pay interest on these reserves. That’s a lot of power. For this reason, banks view the Federal Reserve as the safest financial institution to hold money/reserves. The Federal Reserve will never default or run out of money because they can just create more! Pretty neat.

Although the Fed predominantly uses the IORB to set the FFR, it uses other tools as well. One such tool is called Open Market Operations (OMO). This refers to the Fed buying and selling U.S. Treasury securities. When the Fed buys U.S. bonds, they typically buy bonds from primary dealers with reserves. Primary Dealers refer to the trading counterparties of the New York Fed in its implementation of monetary policy, which typically include large financial intermediaries such as J.P. Morgan, Goldman Sachs, etc. A full list of primary dealers can be found here. When the Fed purchases U.S. Treasury securities, these financial intermediaries have more reserves to go around, thus reducing the relative value of reserves (banks are less willing to pay for reserves) and reducing the FFR. 

Let’s summarize. So far, we know that the Federal Reserve influences the 1-day interest rate (FFR). They do this by directly setting the interest rate on reserves (IORB) and by buying and selling U.S. Treasury securities (OMO). 

Great! But we aren’t just concerned with the 1-day interest rate. What about 1 month? 1 year? 10 years? 30 years? Although the Federal Reserve does not directly set these interest rates, they have strategies for manipulating them.

As briefly mentioned earlier, short-term interest rates strongly influence longer-term interest rates. Think about it. Suppose you continually invest in the 1-day interest rate for 30 days. You alternatively could have invested in a 30-day interest rate. The 30-day interest rate, then, should be roughly on par with the 1-day interest rate. If the expected 1-day interest rates are significantly higher than the 30-day rate, everyone will forgo the 30-day investment for the 1-day investment for 30 days, driving up the price of 1-day investments and reducing the rate. Conversely, if the 30-day interest rate was significantly higher than the expected 1-day rates for 30 days, people would forgo the 1-day investment and bid up the price of the 30-day investment, reducing its yield. 

This phenomenon of short-term rates influencing long-term rates is called the Expectations Hypothesis of the Term Structure of Interest Rates (aka the Expectations Hypothesis). Long name, I know. But this generally shows us how the Federal Reserve also controls long-term interest rates. If investors believe the Federal Reserve will set a certain FFR over 10 years, the 10-year Treasury bill should roughly be equal to the average expected FFR over 10 years. 

In practice, the Federal Reserve often intentionally signals something about the future to manipulate long-term interest rates. This strategy is called forward guidance: where the central bank tells the public about the likely future course of monetary policy. If investors believe the central bank, they will price or reprice long-term interest rates accordingly. 

One other way the Federal Reserve influences long-term interest rates is through Quantitative Easing (QE). QE refers to the central bank purchasing long-term securities like government bonds, mortgage-backed securities, or corporate bonds. In doing so, they bid up the price of these securities which mechanically lowers the yield. This serves as a stimulative policy that injects money into the economy and decreases the interest rate. Notably, the central bank can also ‘reverse’ this policy with Quantitative Tightening (QT). Predictably, this refers to the central bank selling long-term securities, decreasing their price and increasing the interest rate.

QE and QT are relatively recent phenomena, first piloted by the Bank of Japan in 2001. The Federal Reserve first used it in 2008 in response to the Global Financial crisis, and is currently using QT as a tightening tool right now (don’t hate on the Wikipedia citation)!

That was a quick crash course on how the Federal Reserve manipulates interest rates! They create reserves out of thin air, pay interest on those reserves, and use these reserves to buy & sell securities to change interest rates. They also use future expectations of rates to change long-term interest rates. Amazing! But how exactly do interest rates flow through to the economy? Do the nominal rates matter? Or, do the rates adjusted for inflation matter? Why do different interest rates differ? I’ll answer all of these in my next section: How interest rates affect the economy!  

PART 1: Introduction

In my foundational macroeconomics course, the answer was simple: Monetary policy is when the Federal Reserve sets the short-term interest rate. The expectation of short-term interest rates over time comprises longer-term interest rates. Thus, the Federal Reserve determines short-term and long-term interest rates. 

Why do interest rates matter? Well, rates influence the amount of borrowing and spending in an economy. If rates are high, they are said to be ‘restrictive’ in that they limit excess borrowing and spending as the cost of borrowing is high. If rates are low, they are ‘stimulative’ as they incentivize more borrowing and spending. 

Great! Here’s a question, though: Why don’t we keep rates low? That is, why doesn’t the Federal Reserve keep rates at 0? Or, even better, why don’t they set rates at negative levels? That way, it’s super attractive to borrow money, so we’ll have a lot of borrowing and spending which is good for the economy! Well, one consistent theme in life is that too much of a good thing is a bad thing. There are healthy levels of spending, and there are unhealthy levels of spending. If an economy borrows and spends without a commensurate increase in the production of goods and services, a phenomenon called ‘inflation’ occurs. And, if borrowing and spending vastly outpace production, we’ll see something called hyperinflation, where money is so devalued it essentially becomes worthless. Some examples of hyperinflation include Germany after World War I, Zimbabwe in 2008, and Hungary in 1946. Fun fact: Hungary experienced 13,600,000,000,000,000% inflation in a month! Makes 5% annual inflation seem pretty tame, right? (Be sure to search “Zimbabwe hyperinflation” for a visual depiction of what this looks like!)

In sum, the Federal Reserve, or any central bank for that matter, uses interest rates to balance spending and inflation. In fact, the Federal Reserve has a ‘mandate’ to “pursue maximum employment and price stability”. In other words, they seek to keep inflation manageable while supporting borrowing and spending such that firms are healthy enough to hire people looking for jobs. This is great! Now, at a broad level, we understand what the Federal Reserve does. It plays an important role in managing inflation and keeping the labor market healthy. 

But, how exactly does the Fed do this? How do they set the interest rate? What about different kinds of interest rates? Mortgage rates are different from credit card rates which are different from government bond yields. Why? How exactly do interest rates affect the economy? Sure, they make borrowing more or less expensive, but do they do anything else? How do banks play into all of this? The Fed is also a lender of last resort. What does that mean? These questions and more are what I’ll attempt to answer with this series of blog posts. Let’s start with the mechanics.