What Is The Federal Reserve Board Influence on Interest Rates?

The Federal Reserve controls interest rates.

The Federal Reserve Board, headed by the Federal Reserve Chairman, is in charge of the nation's monetary policy. The Fed, as it is known, has a number of very specific goals in mind regarding the U.S. economy, and uses a number of tools to achieve these goals. One of the ways in which it directs policy is through raising or lowering interest rates.

The Fed's Monetary Goals

In order to understand why the Fed does anything, it is important to keep in mind its six ultimate economic goals for the country. According to "Bank Management and Financial Services," these goals are price stability, high employment, economic growth, financial market and institution stability, interest rate stability and foreign-exchange market stability. Interest rates (and the other five goals) are interconnected, so a change in one can affect other areas. For example, lowering interest rates may prompt companies to borrow more money to expand, leading to job growth.

What Are Interest Rates?

The Federal Reserve Bank of New York defines interest rates as the price that a borrower pays to temporarily use another party's funds. When a loan is repaid, the borrower gives back not only the original amount (the principal), but the interest that has accumulated over time. Therefore, if a person borrowed $100 at 5 percent interest for one year, he would have to repay the lender $105. This is a lender's motivation for letting others borrow money--the fact that he will get more back in the end than he gave out.

Fed Control of Interest Rates

The Federal Reserve is technically only in charge of the federal funds rate, which is the interest rate that banks charge each other for borrowing over short periods. However, because these rates affect how much a bank has to pay to borrow money, banks will pass this onto its own borrowers. So, in effect, if the Fed sets a high interest rate, banks will pass this along to other businesses and consumers.

Stimulating the Economy

One of the Fed's goals is interest rate stability, which is why rates usually only change by a quarter of a percent, when they change at all. However, there are times when the Fed does want to use interest rates to affect change. For example, if credit is tight and businesses are not experiencing growth, the Fed may lower interest rates. This makes borrowing easier and cheaper, so it motivates banks to lend money and businesses to borrow more to fuel growth. This growth in turn stimulates the economy and may lead to more jobs as businesses expand.
The Fed may also lower interest rates after a crisis--such as the September 11 terrorist attacks--to lure investors and companies back into business.

Controlling Inflation

Iif the Fed keeps interest rates too low over too long a period, the economy may grow too quickly, leading to inflation. The Fed wants to avoid this scenario, so it will try to raise rates again as soon as possible after cutting them.

Another problem with keeping rates artificially low is that money becomes too easy to borrow, and many people who cannot repay loans are still approved. Additionally, if the Fed keeps rates close to zero in response to a problem and another crisis happens, it will not be able to lower them again, taking away one of its valuable tools for directing monetary policy.

References

• "Bank Management and Financial Services"; Peter S. Rose & Sylvia C. Hudgins; 2005
• Federal Reserve Banks of New York: Interest Rates