Whenever there is any discussion about the Fed raising or lowering interest rates, it makes the news. We start hearing about it before they meet (the who, what, why, when, and how of this meeting would be a good subject for another article), we are reminded that they are meeting today, and then the outcome of the meeting is reported instantaneously. But it is all rather anti-climatic in the end. We regular folks do not really see any effect from it – at least for awhile.
Although anti-climatic, it is still a very interesting subject. One that investors really should understand. Keep in mind, there are a couple of different types of rates. The discount rate is the rate banks pay when they borrow from the Fed. Yes, even banks borrow money sometimes (also a good subject for further discussion). It is the federal funds rate that I am referring to. This is the rate banks charge each other for borrowing short-term money.
This is where things get interesting. Some people might imagine that when the meeting adjourns and a new interest rate is agreed upon, somebody walks over to a computer screen and enters a new rate. It would be nice if it were that easy, but it is not. And this leads us to the first thing you should know about the Fed and interest rates.
* The Fed adjusts rates by buying and selling US Treasury securities.
This may seem a little strange, but it goes to the heart of how the entire monetary system functions. Buying and selling US Treasury securities effects the interest rates because this makes money either more scarce or more plentiful. It is supply and demand. When there is an abundance of something (in this case – money), it becomes somewhat less valuable. When something is in short supply (again – money), a premium is placed on it. When there is more money in the system, rates are lower. When there is less money available, rates rise. And here is the second point I promised you.
* When the Fed purchases US securities, rates fall.
At first, you may think this would be difficult to explain or make the connection between the Fed purchasing US securities and rates falling, but it is really quite simple. In order to purchase these securities, the Fed opens their magic checkbook (you and I are not allowed to have one of these) and creates new money to make the purchase. If the story ended there, that alone would increase the supply of money (inflation). But the truth gets even more fascinating. Who does the Fed buy the treasuries from?
The banks. These purchases transfer the newly created money to the banks thus adding to their reserves. In a super fascinating process (also to be discussed further at another time) the banks in turn create some new money of their own using one of those magic checkbooks that you and I cannot get our hands on. So, in the end, a Fed purchase of treasuries has increased the total supply of money, making money more plentiful, and driving down the interest rates. The flip side of this coin (coin – oh dear, yet another fascinating topic) is our third and final point.
* When the Fed sells US securities, rates rise.
Once again, not hard to understand once you apply the basics of monetary system mechanics. Since you and I do not have one of those magic checkbooks, we have to use real existing money to purchase a security. This transaction transfers money out of the existing money supply and to the Fed, thus taking the money out of circulation. In other words, the total supply of money just decreased (deflation). When the supply of money becomes more scarce, its value rises and interest rates rise with it.
If you can wrap your head around these concepts, then you have largely cracked the monetary system nut. The subject runs much deeper and lots of people who are much smarter than me could go into a lot more detail. But these are the basics. There are many other fascinating aspects of the monetary system – a few of which I alluded to above – which I hope to share with you at another time.