The Federal Reserve and Interest Rates

Few financial issues receive more attention in the press than the Federal Reserve Board's actions with interest rates. It seems there is always some mention of what its chairman, Ben Bernanke, is saying or might say about the economy, interest rates, or the markets in general. 

The Federal Reserve, or Fed, is the independent central bank established by Congress in 1913. One of its primary functions is to help maintain the economic soundness of the US economy by setting the interest rates banks charge each other for overnight loans.

Thousands of banks in the country frequently borrow money or lend money to other banks for short periods, often just overnight. The Fed oversees that activity and sets the interest rates on the borrowing and lending. This type of institutional borrowing helps to keep liquidity in the financial system and the banking system strong.

How it works

The Federal Reserve has a 12-member Federal Open Market Committee that meets eight times a year to review the economy and make changes to the overnight loan rates. For the past few decades, the Fed has tried very hard to keep inflation under control by managing the overnight interest rates.

The members review all types of information and keep their meetings and decision-making process secret. At the end of their meetings, there is an announcement of any changes they make. These announcements are anxiously awaited and studied very carefully by financial professionals to get a glimpse into the thinking of these decision makers.

Why is this important

The cost of borrowing has direct effects on costs for businesses and individuals. By raising or lowering this central interest rate, the Fed can influence how fast or how slow the economy will grow or contract. However, it usually takes many months to see the full effect of any changes they make.

What to look for

The Fed usually makes several small changes to rates rather than one large change. For example, they raised rates six separate times in the 11 months ending in May 2000. As that happened, the economy started to slow down. In early 2001, the Fed started lowering rates in an attempt to help cushion the economic downturn. It also lowered rates in the aftermath of the September 11, 2001 attacks. All told, the Fed lowered interest rates 11 times in 2001. In November 2002 and the middle of 2003, the Fed lowered rates again, in an attempt to stimulate the economy. 

In the summer of 2004, the Fed started gradually raising rates from the historic low levels. Their stated belief is that the economy has started to recover and that by gently moving rates higher, they will be able to keep inflation in check without curbing the ongoing recovery. The gradual increasing of rates has continued from the summer of 2004 through the summer of 2006. The Fed increased the overnight interest rate 17 times before not raising the rate at their August 2006 meeting. The rate remained constant through the summer of 2007. In the fall of 2007, the Fed started reducing rates.

In 2008, the Fed reduced rates several times in response to a weakening economy and to provide additional liquidity as financial markets dealt with uncertainties in the sub-prime mortgage and other credit markets.

In the late summer and fall of 2008, Congress granted the Federal Reserve significantly more authority to deal with the turmoil in the financial markets. This includes purchasing illiquid securities from institutions, making loans to troubled firms, and making investments in banks and other institutions to provide additional capital for their operations.

How does the Fed affect consumers?

Many consumer interest rates are strongly influenced by changes made by the Fed. Usually when the Fed raises or lowers rates, the prime rate (the rate charged to large corporations by banks) changes almost immediately. Many credit card and consumer loan rates are tied directly to the prime rate. In addition, mortgage rates are also greatly influenced by the Fed rate changes.

Since the stock and bond markets are closely interwoven, changes by the Fed can also affect the stock market. While there is no direct link, the market tends to react positively to rate cuts and negatively to rate increases. Usually, the markets are already sensing what actions the Fed may take, and prices may rise or fall long before the Fed actually meets and announces any changes.

What should you do?

There is probably nothing specific that an individual investor should do about the Federal Reserve Board's actions. However, it makes sense to watch what they say and do, and to try to put their actions into your overall financial thinking.


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