How does the Federal Reserve raise rates, anyway?
If you have ever thought about how the Federal Reserve sets interest rates, you might have thought it went a little something like this: the Fed raises its federal funds rate, which sets the rate banks charge to loan money to each other, and that causes other rates to climb.
“That’s not a terrible shorthand for the way things used to work,” says Binyamin Appelbaum, a Washington correspondent for The New York Times.
While analysts, economists and investors are eagerly waiting to see whether the Federal Reserve raises interest rates after its meeting later this week, Appelbaum drove into the mechanics of how such a rate hike would work in this weekend’s paper.
In short, Appelbaum says, the Fed pumped so much money into the economy as a response to the financial crisis, that its old way of raising rates won’t work anymore.
Its new plan has two basic parts, he says: “One of which is a system for paying banks not to be as aggressive in their lending, and the other is a system for paying non-banks, other kinds of financial firms, to also be more cautious.
The Fed hopes those actions achieve the same rate-increasing outcome as its previous technique. Appelbaum says in theory and in small test runs, the idea seems sound.
Part of the significance of the change is its newness.
“In terms of the underlying mechanics of reserves and currency and all that, that hasn’t changed since the ’60s, I think,” says Joe Gagnon, a senior fellow with the Peterson Institute for International Economics, who used to work at the Fed.
If everything goes according to plan, most people won’t even notice the new approach, says Kevin Jacques, a professor at Baldwin Wallace University in Ohio.
But, Jacques warns, “we could see some unintended consequences, and if we do, what will they look like, where will they appear and how will they influence financial markets?
Those are questions we won’t be able to answer until the Fed decides to change rates — whenever that may be.
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