A number of times a year, the board members of the Federal Reserve meet to discuss interest rate policy. It is an event that stops Wall Street, as traders literally do nothing for the day and a half meeting, instead waiting for the pronouncement from on high regarding interest rate policy. Will the Fed raise, lower, or maintain the current level of interest rates? At 2:15 Eastern Time, the Fed releases the announcement and an entire profession of people devoted solely to deciphering fedspeak pour over the fed statement, trying to discern what the governors really mean. After all the dust settles, the Fed goes about its business implementing interest rate policy. The question now becomes "how do they do that?" Below, I will walk you through the baby steps of interest rate policy, hopefully untangling the web of mystery surrounding how interest rates come into being.
First, there is a key definition to explain:
bank reserves. The best way to explain reserves is to give a brief account of banking history, which started in Italy during the Renaissance. In those days, there were no banks. Instead, people would leave their gold (the medium of currency) with their respective jewelers. After awhile, the jewelers realized not everybody needed their money at the same time. For example, one customer would leave their gold before they went to another city where they could be for 6 months or more. Another customer would be traveling to the Far East on a merchant trip and would not need his money for a year or more. I think you get the idea. Anyway, the jewelers realized they only needed to keep a small amount of money on hand - their reserve -- in case a customer came back to get their money. This is the beginning of the modern concept of
reserve banking.
Let's take this example and apply it to a modern bank. Suppose your bank has $1,000,000 of total deposits. Guess what? Your bank does not keep all that money on the premises at all times. They only keep a percentage, or their reserve, at the branches for customer redemption.
In addition, banks make loans based on their total reserves. However, banks must keep their total loans to a certain ratio of reserves. This relationship is called the loan/reserve ratio.
Let's take this one more step...stay with me... the next step is really easy.
Because banks must keep their loans and reserves in a certain ratio, the amount of reserves a bank has is critical to the total amount of loans it can make.
Now let's bring interest rates into this explanation. Suppose you have a little bit of money to lend out and you find a suitable creditor. Will you charge him a high or a low interest rate? If you said high, pat yourself on the back. This is simple supply and demand. When there is a limited supply of almost any good, it becomes more expensive. Suppose you have a lot of money to lend. You'll charge a lower interest rate because a larger amount of a good lowers its price.
To sum up to this point: modern banks practice reserve banking, where they lend money in proportion to the amount of their reserves. The more reserves they have, the lower the interest rate they will charge and the fewer reserves they have, the more interest they will charge.
Enter the Fed, which sits at the center of the US financial system. The best analogy is they are the tire's hub and the rest of the US financial system are the tires' spokes. Just as all roads lead to Rome, all financial roads eventually lead to the Fed.
Now, let's say the Fed has decided to raise interest rates 25 basis points. Member banks don't just start charging higher interest rates. Instead, the Federal Reserve must take money out of the financial system. Remember above where you had a little bit of money to lend and you charged a higher interest rate? This situation is exactly what the Fed is going to create through its open market operations.
To raise interest rates, the Fed wants to lower the total amount of reserves banks have on hand. This will make the remaining reserves more valuable forcing the banks to charge a higher interest rate for them. Through its open market operations, the Fed sells bonds to member banks, which in turn pay cash from their reserves to the Fed. This process lowers the amount of reserves member banks have on hand to make loans. Fewer reserves = higher interest rates.
To lower interest rates, the Fed reverses the process. Here the Fed wants to increase the amount of money in the system. To implement this policy, the Fed will buy their bonds from the banks and in turn pay the banks cash. This increases member banks total reserves allowing them to charge a lower interest rate for loans.
These transactions do not happen overnight. They take time to implement. There is an old adage among traders that it takes about 6-9 months for changes in interest rate policy to work their way through the system. If you look at the relationship between interest rate policy changes and GDO growth you will notice a 6-9 month lag between the Fed's setting a policy and that policy's effect on the economy as whole.
And that's Federal Reserve 101. I hope you understand a bit more about how the interacts with the economy and member banks, and how interest rate policy is implemented. If you have any questions, please ask.
Also, for more information, here are a few books which are beautifully written and very informative.
Against the Gods, a History of Risk
Secrets of the Temple
If you want a book that delves really deeply into this topic, get a Monetary History of the United States.