I’ve often read the news or in lessons, that government can engage in the monetary policy by lowering or raising the interest rate. I wonder how’s the mechanics of this?
Does the government simply provide loans with lower/higher interest rate, and this will force other people to follow suit?
It’s hair splitting just a bit, but the government does not directly control interest rates, as if by an act of Congress or a presidential proclamation, but the Federal Reserve System (Fed) that does this. It works more or less as follows: Commercial banks routinely take out short-term loans from the Fed to fund their day-to-day operations, so the Fed raises or lowers its short-term interest rate to tighten or loosen the availability of credit and money in the economy. In order to remain profitable, banks and other commercial/retail lending institutions have to follow suit.
There are other tools they can use, but adjusting the interest rate is by far the most commonly used method.
Thanks for the correction.
How do you mean? And does this mean that, from technical point of view, it’s trivial for the central bank to do this?
Suppose FriedoBank borrows some money from the Federal Reserve at 1% interest. A customer then comes in and asks for a loan from FriedoBank. If the bank charges that customer 1%, they won’t make any money, since they’re also paying 1% interest to the federal reserve. So they charge the customer 2%.
Now the Federal Reserve decides they want to reduce the money supply somewhat. They raise their interest rates. There are actually a few different interest rates depending on which products they want to tweak, but let’s pretend there’s only one. So now FriedoBank has to pay 3% interest to borrow money from the Fed. If a customer comes in for a loan, they will have to charge 4% or more to make any money. This makes credit more expensive, which means fewer people and companies will borrow money, which means there is less money supply.
That’s a bit oversimplified, but is essentially how it works. The Fed can change their interest rates any time they want, but there’s no requirement that banks actually borrow money from them.
Worth adding that when FriedoBank borrows the money they do so at a fixed rate for a fixed period. This means that customer one’s loan at 2% stays profitable, even when interest rates go up.
One way for the Fed to influence interest rates is to buy (sending rates down) or sell (sending rates up) U.S. Treasury debt. It can influence short-term interest rates much more than long-term rates. But big as it is, the Fed can’t completely control interest rates this way – J.P. Morgan Chase is also a very big player. :eek:
So a more important way is for the Fed just to announce its intentions. If JPM knows the Fed will be buying debt, it will want to buy it too to take advantage of the price rise (or resp. sell/price decline).
It’s off-topic, but there is a key fact about interest rates. A strong economy will have strong profits, high demand for money, and high interest rates. So, when a Central Bank lowers interest rates hoping to stimulate the economy, it’s hoping that the eventual result will be higher interest rates! If instead, the surplus money just results in rising prices of stocks and other assets then … well, I’ll let the experts come along and make predictions.
Reserve banking is a little more complicated – essentially a bank is authorized to create credit up to some multiple of its reserves – if a bank has more money than that loaned out on a given day, they are required to borrow the difference, which they can do at optimal rates from the federal reserve system, at the rate set by the Fed.
More info here: Fractional-reserve banking - Wikipedia
Wile all of this is true, almost all short term bank borrowing is done from other banks in the federal funds market. The Fed coordinates and clears this market, but is not making loans; those are from other banks who have excess reserves.
Banks can borrow from the government via the “discount window.” However, the discount rate has typically been above the Fed Funds rate and the discount window is not usually used. There is also a bit of a stigma associated with borrowing at the discount window as it indicates your bank is weak.
The Fed “controls” interest rates and the money supply by buying or selling the Treasury bonds it holds. When it buys bonds, it gives out cash increasing the money supply and at the same time pushing bond prices up, lowering their yields, and likely decreasing other interest rates through competitive pressure. This is expansionary for the economy as the cash tends to get spent and the lower interest rates tend to increase investment by companies.
So while the Fed can set the discount rate, it can’t really set the important rates which are the Fed Funds rate, the repo rate, and the Treasury rates. It does have a strong influence on them though.
When the Fed changes the rate, isn’t it rather like turning a barge? Of course commercial bank customers’ fixed rate loan terms continue in force, and the full effect of a rate change doesn’t happen overnight. But in the middle and long term, it does have its effects. The new federal funds rate will be factored into new business that the bank transacts.
OTOH, in the near term, or even overnight, it’s typical to see changes in foreign exchange rates and stock market indices following a rate change. When the interest rate is raised, bonds become more attractive investments and the dollar usually strengthens relative to foreign currency.
And the converse…
Thanks guys. So I’m still a bit confused - it seems that there are several ways to do so. By raising/lowering the rate it charges banks to borrow its money, and by buying/selling Treasury bonds. Which one is more dominant, and how do they interact? Does the fed normally do both simultaneously? Or just one?
As I already stated earlier, the main power is just the suggestion. When they announce what their interest rate targets are, banks will comply. If they know FRB will be buying (or selling) Treasury notes, they’ll want to buy (or sell) them also, thus helping FRB reach its goal. (This is similar to “front-running”, but is of course legal, indeed is intentional government policy.)
This is sort of correct. The rates that central banks have the most control over are the very short term rates – overnight, one-day, two-day, one-week-ish kinds of things. Rates for long-term loans (e.g. 5Y) are much more “sticky”. (Interest rate models often have to take into account the fact that the short end of the yield curve has significantly different dynamics than the long end because of this).
As noted, markets respond very quickly to expectations. Especially because interest rates are so critical to the valuation of things. If you’re expecting a certain amount of cash to come in in a year, a lowering of interest rates makes that cash flow more valuable, even if its nominal amount is still the same.
The Federal Open Market Committee (FOMC) decides the Federal Funds Rate (FFR) that is used by banks to borrow from the fed. Bank to bank lending is done at the Prime Rate (PR), which is greater than the FFR.
The buying and selling of T-bills is a part of Open Market Operations (OMO) that is conducted by the Federal “Fed” Reserve. [URL=“”]
This is incorrect, as posters in this thread have already explained and as your own cite says. The Fed does strongly influence the federal funds rate, but this is not the rate for borrowing from the central bank itself.
My emphasis. That’s from the very first paragraph of your link. Fed funds is bank-to-bank lending.
Banks lend money which is kept in their reserve accounts at the Fed, but they are not borrowing from the Fed. They’re borrowing from each other.
This is also incorrect, as is also explained in your own cite.
The Prime Rate is a rate at which banks lend to their most dependable corporate customers (although some question how reliable this figure, as reported, actually is in today’s financial world).
Lending from the Fed itself is done through the discount window at the discount rate.
Another misconception in your post is the idea that borrowing from the central bank is less expensive than banks borrowing from each other. This can happen but it’s generally not the case.
Different central banks have different mechanics of how, exactly, to influence market interest rates.
The Eurosystem (the central bank system managing the euro, consisting of the European Central Bank and the national central bank of the euro area countries) uses a system similar to what has been described by some users: Direct central bank lending to commercial banks. For that purpose, the Eurosystem maintains a number of possibilities for commercial banks to borrow from the central bank. The most important of these is the Main Refinancing Operation (MRO), the rate of which is commonly cited as the euro area’s key rate. Essentially, it’s a credit line available to commercial banks once a week with a maturity of one week: Each Wednesday, commercial banks can participate in an open tender procedure whereby they can draw from the central bank money - currently in an unlimited amount, provided that they post sufficient collateral for the amount they want to borrow; in the past, the overall amount allocated to all banks was limited and auctioned off among banks in an auction-like procedure. Repayment is seven days later, and the interest rate is currently 0.05%. The Eurosystem also operates other possibilities for commercial banks to borrow, such as the Marginal Lending Facility (which is available every day, repayable the next day, and carries an interest rate of currently 0.3%) or long-term operations of several months or up to three years, as introduced during the crisis. The most important monetary instrument of the Eurosystem still is, however, the MRO.
The Federal Reserve System (the central bank system operating the dollar, consisting of the Federal Reserve Board in Washington and the regional Federal Reserve Banks) operates differently. Traditionally, the Fed would not conduct direct lending to commercial banks (I believe facilities to do so have been introduced during the financial crisis, however). What the Fed does is to announce a target for the Federal Funds Rate (FFR). The FFR is an indicator for the going market rates that commercial banks charge each other when lending to each other on the interbank market. Consequently, the effective FFR cannot be directly manipulated by the Fed, since the FFR is just a result of the deals bilaterally negotiated among private banks. What the Fed can do, however, is to intervene on money markets when the effective FFR diverges from the target set by the Fed. Currently, the target FFR is not a fixed rate but a band: Effective FFR is expected to be between 0 and 0.25%. If the effective FFR were to drop below the target band, the Fed could intervene by selling Treasury Bonds or Treasury Bills, which would have the effect of driving down market rates. Consequently, if the effective FFR were to rise above the target band, the Fed could buy Treasury Bonds or Bills, which would put downward pressure on market interest rates. It’s an indirect influence on market rates, however, unlike the direct lending programmes operated in the case of the Eurosystem.
Good post, Schnitte. But one small note:
The Fed has always had its discount window from which banks could borrow directly. It’s been there forever. It’s used on relatively rare occasions.
But there’s long been a stigma attached to this borrowing. It’s normally kept a point or so higher than the fed funds rate, and it’s collateralized borrowing unlike fed funds. Which means to borrow from this window is a sign of weakness.
So the Fed had a couple important reasons to introduce new facilities, on top of the usual discount window, during the financial crisis. The new facilities wouldn’t have the same historical stigma since they were a brand new special case of borrowing, a temporary window from which all institutions were encouraged to borrow; and also with the new facilities, the Fed could ostentatiously change the rules for what they were accepting as collateral. Standards for collateral were considerably lowered.
Today they’re back to just the discount window, rarely used, with no other special-case facilities.
Thanks for that addition, Hellestal. Interesting to know how different market perceptions of borrowing from the central bank are in the U.S. as opposed to Europe, where it’s a perfectly normal thing.
It might also be worth mentioning that some central banks, in addition to lending to commercial banks, operate programmes whereby the central bank borrows from commercial banks. The Eurosystem does so under the name of deposit facility: Commercial banks can put unlimited amounts of money into that facility, which will be repaid the next day. The reason why the central bank does that is not to fund its own operations (iut can do so just by creating fresh fiat money; it is not dependent on external financing) but to have a tool that allows for the central bank to absorb excess liquidity. In effect, the deposit facility acts as the lower limit of the band within which interbank market rates (the interest rate at which commercial banks lend to each other) for overnight loans oscillate: No bank would lend money to another bank for less than the deposit facility rate, since you can always obtain the deposit facility rate at the central bank. Conversely, no bank would borrow money from another bank at rates higher than the marginal lending facility rate, since you can always get money from the central bank at the marginal lending facility rate. That’s why the deposit facility rate is always the lowest of the three key rates published by the ECB (the others are the marginal lending facility rate and the MRO rate). In the current low-interest rate environment, the deposit facility rate is actually negative at -0.2%, effectively penalising banks for placing money at the central bank instead of lending it to other banks.