(thebalance) The Federal Reserve raises or lowers interest rates through the Federal Open Market Committee (FOMC). The Committee conducts open market operations for the Federal Reserve System.
After reviewing current economic data, the FOMC sets a target for the fed funds rate at one of its eight meetings. But what are fed funds, and how do they influence interest rates?
- The Fed sets a target for the fed funds rate. At its Nov. 4-5, 2020 meeting, the FOMC said it would maintain the target fed funds rate at a range of 0% to 0.25%.
- By law, banks set their own effective fed funds rate.
- The Fed heavily influences this rate using open market operations, the reserve requirement, and the discount rate.
- The Fed can also pay interest on bank reserves and purchase repos or reverse repos to fine tune interest rates.
How the Fed Convinces Banks to Raise Their Rates
The Fed typically requires banks to hold a percentage of their deposits in reserves each night. If they don’t have enough reserves, they will borrow what’s needed.
The actual rate that banks set is called the effective fed funds rate. The Fed can only set a target for the fed funds rate since banks are private businesses that can set any rate they wish.
Warning: In March 2020, the FOMC reduced the reserve requirement to effectively zero, which it will retain until it is “confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”