Why Does the Federal Reserve Artificially Set Interest Rates? Wouldn’t the Market Organically Set Interest Rates?

In the financial world, the Federal Reserve does not set multiple interest rates. Instead, it targets a specific interest rate, known as the overnight rate. The Federal Reserve lends to banks overnight to meet reserve requirements, among other needs. This overnight rate is significantly influential and often correlates strongly with other interest rates—although this correlation can weaken in times of economic instability or excessive money printing.

How the Federal Reserve Influences Interest Rates

While the Federal Reserve does not directly set the exact interest rate on mortgages, credit cards, or savings accounts, it uses various tools to influence the overall market. Two primary methods include:

The Interest Rate on Reserve Balances: This is the interest rate paid to banks on their reserve balances held in their account at the Federal Reserve. The Discount Rate: This is the rate at which banks can borrow from the Federal Reserve via overnight loans.

By setting these two rates, the Federal Reserve establishes a range for the Federal Funds Rate (the rate at which banks lend to each other overnight). This Federal Funds Rate then serves as a benchmark for a wide range of other interest rates in the market.

Why Does the Fed Prefer Not to Let Interest Rates Float?

Historically, if interbank interest rates were allowed to float naturally, they would tend to remain close to zero percent. Yet, the Federal Reserve prefers to maintain a target interest rate that is unnaturally high. This is to achieve several important objectives:

Controlling Inflation: By keeping interest rates higher, the Federal Reserve can help manage inflation levels. Higher interest rates make borrowing more expensive, which can curb spending and slow down inflation. Stock Market Stability: The Federal Reserve's interest rates are closely tied to the performance of the stock market. Higher interest rates can make equity investments less attractive, which can help stabilize the stock market. Economic Growth: The Federal Reserve aims to strike a balance by keeping interest rates low enough to encourage borrowing and investment. However, they also need to ensure that the economy does not overheat, which can lead to inflationary pressures. Cycle Management: Regularly adjusting interest rates allows the Federal Reserve to manage economic cycles, including periods of recession and expansion.

The Impact of Central Bank Policies on Economic Systems

Central bank policies have a profound impact on the financial system. Consider the government and the banks as parts of a larger financial ecosystem. The government can be seen as a “Conglomerate,” with banks as “Subsidiaries.” Both entities need each other to maintain economic balance and equilibrium:

The Role of Banks and the Stock Market in Budgets and Financial Systems

The stock market and banks play crucial roles in budgeting and the overall financial system. Banks facilitate credit and capital flows, enabling businesses and individuals to access funds. In return, banks earn a profit through interest rates and fees. The stock market, on the other hand, provides a platform for businesses to raise capital and for investors to earn returns. When these entities work together effectively, it can lead to a stable and growing economy.

Conclusion

The Federal Reserve’s control over interest rates is a complex yet crucial aspect of the financial system. While the market has some influence, it is ultimately the Federal Reserve that dictates the overall interest rate environment. This is done to manage inflation, stabilize the economy, and ensure a healthy balance between economic growth and financial stability.