Interest Rate Determination

When the Fed lowers its target federal funds rate and discount rate, it signals an expanded money supply and lower overall interest rates.

When the Fed raises its target federal funds rate and discount rate, it signals a reduced money supply and higher overall interest rates.

In news stories immediately after the FOMC meets, one is likely to read that the Fed raised (or lowered) interest rates yesterday. For many who read this, it sounds as if the Fed "sets" the interest rates charged by banks. In actuality, the Fed only sets one interest rate, and that is the discount rate. The rate that is announced every month is not the discount rate, but the federal funds rate. The federal funds rate is the interest rate banks charge each other for short-term (usually overnight) loans. The Fed does not actually set the federal funds rate, but it does employ open market operations to target this rate at a desired level. Thus what is announced at the end of each FOMC meeting is the target federal funds rate.

The main reason banks make overnight loans to each other each day is to maintain their reserve requirements. Each day some banks may end up with excess reserves. Other banks may find themselves short of reserves. Those banks with excess reserves would prefer to loan out as much as possible at some rate of interest rather than earning nothing. Those banks short of reserves are required by law to raise up their reserves to the required level. Thus banks lend money to each other each night.

If there is excess demand for money overnight relative to supply, the Fed keeps the discount window open. The discount window refers to a policy by the Fed to lend money on a short-term basis (usually overnight) to financial institutions. The interest rate charged on these loans is called the discount rate. Before 2003, banks needed to demonstrate that they had exhausted all other options before coming to the discount window. After 2003, the Fed revised its policies and set a primary credit discount rate and a secondary credit discount rate. Primary credit rates are set 100 basis points (1 percent) above the federal funds rate and are available only to very sound, financially strong banks. Secondary credit rates are set 150 basis points above the federal funds target rate and are available to banks not eligible for primary credit. Although these loans are typically made overnight, they can be extended for longer periods and can be used for any purpose.

Before the changes in discount window policy in 2003, very few banks sought loans through the discount window. Hence, it was not a very effective lever in monetary policy.

However, the announcement of the federal funds target rate after each FOMC meeting does remain an important signal about the future course of Fed monetary policy. If the FOMC announces a lower target federal funds rate, one should expect expanded money supply, perhaps achieved through open market operations. If the FOMC announces a higher target rate, one should prepare for a more contractionary monetary policy to follow.