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How the Federal Reserve Controls Interest Rates

How the Federal Reserve Controls Interest Rates

The Federal Reserve has recently been in the public eye for raising interest rates to combat inflation. From food and gas to electronics and loans, you’ve probably had to deal with increased prices on everyday products eating at your budget.
But what exactly is the Federal Reserve? How do they control interest rates and what purpose does controlling rates serve?

What is the Federal Reserve?

The Federal Reserve, also known as the Fed, is the central bank of the United States. It’s responsible for promoting financial stability and maintaining the state of the nation’s economy.

The Fed looks to stabilize and grow the nation’s system by keeping prices in check while maintaining high employment. One of the tools that the Fed uses to meet its goals is controlling interest rates through the cost of fed funds.

What are Fed Funds?

Fed funds are the reserves that banks keep at any of the 12 regional Federal Reserve Banks across the US.

The Federal Open Market Committee (FOMC) is responsible for setting the nation’s monetary policy and sets a target for the fed funds rate. The federal funds rate is the interest rate banks charge each other for overnight loans. This rate affects the cost of borrowing money.

How Does It Work?

A higher fed funds rate means it's more expensive to borrow money, which can lead to slower economic growth. On the other hand, a lower rate makes borrowing cheaper, leading to faster growth.

The FOMC meets eight times a year to review economic conditions while setting the target for the federal funds rate. They also review financial data such as inflation and unemployment to determine the appropriate level for the fed funds rate.

In theory, a higher rate results in less consumer spending, slowing inflation. However, it can also lead to businesses cutting employees, especially if there are concerns of a looming recession.

Ultimately without stability and regulation, there wouldn’t be anything in place to prevent or dampen financial panics. Even though increasing rates may temporarily affect everybody, it also provides a strategy for promoting future economic growth and stability.

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