- Arguably the most important tool of the Federal Reserve (or, simply, "Fed") for lowering interest rates is called "open market operations." This is an act of monetary policy that adds or subtracts money to the U.S. banking system. It does this through the purchase and sale of federal securities. When the Fed sells securities, it drains money from the banking system, as the banks buy up government debt. In exchange, the banks have invested in government debt instruments, such as bonds. When the Fed buys these securities back, it does the opposite: money is injected into the banking system.
- The Fed controls interest rates mostly through targeting what is called the federal funds rate, or the rate that banks charge each other for short-term, overnight loans of funds kept on deposit at the Federal Reserve. All banks keep these deposits with the Fed in order to meet their minimum reserve requirements. The problem with targeting the federal funds rate is that it is set by market activity, and not by Federal Reserve policy. The Fed can only indirectly influence the federal funds rate, which it does through open market operations.
- The Fed can directly set the discount window rate, or the rate for direct overnight loans from the Fed. This is typically set at a very high rate to encourage banks to borrow from other sources instead.
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Decisions regarding interest rates are reached by the Federal Open Market Committee (FOMC). This group consists of the seven members of the Federal Reserve Board, plus five of the twelve Federal Reserve Bank presidents. Of the latter, the president of the Federal Reserve Bank of New York is always a member, with other four slots being filled on a 1-year, rotating basis by the other presidents.
The FOMC has a regularly scheduled meeting every eight weeks. After reviewing the materials and reports prepared by the Federal Reserve staff, the FOMC discusses circumstances and policy options, and tries to reach a consensus on what to do. FOMC decisions are not reached by straight majority voting. This consensus is then given to the president of the Federal Reserve Bank of New York, who is responsible for implementing any policy regarding Open Market Operations. When the Fed does state that it is seeking a new target for the Federal Funds Rate, it is usually raising or lowering its target by one-quarter or one-half a percentage point. - Because actions by the Fed can increase or decrease what it costs banks to borrow money, it trickles down into what interest rates the banks charge customers. Typically, banks will set their prime interest rate at three or four points higher than whatever the federal funds rate is. The discount window rate is also influential, but not to the same degree as the federal funds rate.
