Last week, the Senate Banking Committee held a hearing to vet President Trump’s nominee for Chairman of the Federal Reserve Board of Governors. The president’s pick, Kevin Warsh, previously served as a member of the board from 2006 to 2011 and is currently a visiting scholar at the Hoover Institution at Stanford University. If confirmed by the Senate, Warsh will replace current Chairman Jerome Powell, whose term expires in May.
Mr. Warsh faced aggressive questioning on several topics from his views on the independence of the Fed to his own personal fortune, but at the policy level the question of interest rates remained front and center.
As most Americans witnessed over the past 4 years, the primary tool in the Fed’s arsenal to combat excess inflation is its ability to influence the level of interest rates. In response to the sharp rise in prices in 2022, during which inflation briefly touched 9%, the central bank hiked its benchmark interest rate from near zero to 5.5% over several months, the fastest pace on record. The rate has since been lowered to 3.75%.
The Fed’s action was belated but largely successful, with inflation now down to around 3%, but the ongoing debate surrounding the appropriate level of interest rates today was on full display at the confirmation hearings. All of which suggests a basic question: exactly how does the Fed exert control over interest rates?
The Federal Reserve System was created in 1913 by the Federal Reserve Act. The system consists of a semi-independent Board of Governors appointed by the president and confirmed by the Senate, and 12 regional Federal Reserve Banks. The regional banks are private entities, owned by commercial banks that belong to the Federal Reserve System.
The primary mandate of the Federal Reserve is to maintain appropriate monetary policy to fulfil 2 somewhat disparate mandates: price stability and full employment. It receives no taxpayer funds, and is entirely self-supported by interest income on its portfolio plus fees from member banks. Any profit remaining after expenses must be turned over to the US Treasury.
Once upon a time, the preferred channel through which the central bank operated was manipulation of the money supply, the total stock of U.S. Dollars in circulation. However, the expansion of financial innovation and the proliferation of alternative payment systems made it difficult to measure, much less control, the quantity of money, and the Fed largely abandoned monetary targeting in 1982. Today, the primary focus of the bank is interest rate policy, raising rates to cool an overheated economy or reducing borrowing costs to help pull the ox out of the ditch during downturns.
How do they do it? First, the Fed determines how much commercial banks must set aside as reserves as well as the interest rate paid on those reserves. Required reserves must be held on deposit with the Fed and are not available for banks to lend out, broadly affecting the availability of credit in the system. This high level policy does not change often and typically only during crises.
Second, the central bank may lend to commercial banks at a rate known as the Discount Rate, again set by the Board of Governors and only infrequently tapped, as it was during the global financial crisis in 2006.
Third, and most commonly, the Federal Reserve engages in market transactions to influence another key interest rate called the Federal Funds rate. This is the rate at which member banks may borrow from each other at the end of the day to satisfy their reserve targets with the Fed. Banks with surpluses lend to banks seeking additional capital (typically overnight) at the Fed Funds rate. Interbank overnight borrowing is common to balance the books daily as creation and retirement of bank loans affect reserve holdings.
Here is where it gets interesting. Unlike the Discount Rate, the Fed cannot set the fed funds rate by fiat and must engage in what are called “open market operations”. The board can influence this short-term rate by buying or selling Government securities in the open market, influencing the price and therefore the yield or interest rate in the marketplace.
Suppose that the US economy is entering a recession (think covid). To stimulate growth, the Fed wishes to coax interest rates lower by cutting the fed funds rate and encouraging more borrowing. In this case, the Federal Open Market Committee (a subsidiary of the Fed) purchases US Government securities from member banks on the open market and deposits the proceeds into these banks’ reserve accounts at the Fed. This action reduces the demand for fed funds (since bank reserves have increased), driving the rate lower.
The direct impact of a change in the fed funds rate is relatively minor, but ripples indirectly throughout the broader banking and lending infrastructure. Faced with higher reserve costs, banks raise the interest rates they charge starting with the prime rate, the price of loans for their best customers. Same for government borrowing, as the market interest rates on U.S. treasury securities like the 10 year Treasury bond also rise or fall with the fed funds rate.
Homebuyers are well acquainted with the effect, as mortgage rates are based largely on the 10 year Treasury bond. Average 30 year fixed home loan rates have risen from around 2.5% in 2020 to over 6% today.
The Federal Reserve presently stands at an inflection point, animating the debate over rate policy and the choice of a new Fed Chair. Inflation has declined significantly since the pandemic disruption, lending support to arguments of the doves who favor additional rate cuts. Yet tariffs and the sharp increase in energy prices from the Iran war have reversed the disinflationary progress, supporting hawks calling for stasis or even rate hikes to head off anticipated inflation dead ahead. Meanwhile, the current Chairman of the Federal Reserve has faced unprecedented political and legal assaults from the president. Welcome aboard, Kevin Warsh, and best of luck.