The Federal Reserve is one of the most powerful institutions in the country, but very few people know what they actually do. The Fed, as it is called, is lead by a board of economists chaired by Janet Yellen. The Fed was set up to help control the financial system with the goal of keeping employment low and inflation under control. The main way they seek to do this is by setting short-term inter-bank lending rates, which is an obscure yet extremely powerful way to impact virtually every economic transaction in the country.
The federal interbank rate is the percentage rate that banks lend money to each other. The Federal Reserve has the power to lower or raise these rates at will which they regularly do base on their analysis of the economy. This has a profound effect on the economy and financial transactions.
In particular, a low fed funds rate means that banks can lend money to each other cheaply and can then lend it out to customers cheaply. That, in turn, encourages businesses to borrow more money because the cost is less. Theoretically, if they borrow more money they will invest more in their businesses and hire more workers which will stimulate the economy. So the effect of lowering interest rates should be to improve the economy’s capacity.
On the flip side, anyone that saves money will be hurt by lowering interest rates. Because banks will be lending at lower rates, they will have lower profits and will not be able to pay depositors a higher rate. The people that have diligently saved funds in the bank will not be rewarded with interest on their money. They will have to take cash out of the bank and invest it into more aggressive opportunities such as municipal bonds, corporate bonds or equities. Again, this should serve to juice the economy by providing businesses with more cash to fund expansion. That produces more capital goods orders and more jobs.
So if lowering rates provides so many benefits, why would the Fed ever raise rates? The answer is that the Fed is keeping a balance between inflation and employment. If there is “over-investment” from too many loans and investments, then inflation will increase too quickly. The cost of gas, food, housing and everything else will rise and the poorest will be punished. Additionally, the if there is too much investment, the prices of assets could rise too quickly and eventually lead to a crash which causes far worse damage. For that reason, the Federal Reserve tries to keep the economy in relative balance by raising the interbank rate during periods of economic expansion.
Historically, the interbank rate has fluctuated wildly. During the 1980s, there was tremendous inflation and Fed Chairman Paul Volcker decided to raise the rate into the teens. In the short-term, that caused tremendous pain for businesses and other borrowers. In the long-term, it broke the curse of inflation and put the US economy on a path for massive expansion.
During the 2008 financial crisis, the economy went into a tailspin with all financial assets crashing towards zero. The Federal Reserve was in a bind and ended up dropping interbank rates all the way to zero. Chair Ben Bernanke knew that with an economy on the brink, interbank rates should not be holding any individual or company from borrowing and investing the proceeds.
Today, the Fed is slowly raising the rates again as the economy is expanding and has a low unemployment rate. Inflation is under control but has the potential to rise again. Only time will tell what the result of these interbanks rate changes will be.
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