Markets, Not Janet Yellen, Should Set Interest Rates

Federal Reserve Chair Janet Yellen delivered her semiannual monetary policy report to Congress on July 15, 2015. Speaking before the House Committee on Financial Services in Washington, D.C., Yellen said that trends in the U.S. economy suggested it may be the right time for the Federal Reserve to start nudging up the Federal Funds rate – the interest rate banks charge each other – after years at nearly zero.

In the usual method of Federal Reserve statements, Janet Yellen did not tie a rise in interest rates to any particular period or date before the end of the year. Such a change in interest rates and monetary policy will depend entirely upon how the Federal Reserve policymakers read the trends in employment, gross domestic product and price inflation.

How the Fed Creates Money and Influences Interest Rates. The Federal Funds rate, as Yellen stated, is a key tool of Federal Reserve policy. Federal Reserve rules require banks to maintain a certain amount of cash reserves against outstanding depositor liabilities. On a daily basis, money deposits flow in and money withdrawals flow out of every bank and financial institution. Sometimes banks find withdrawals have exceeded deposits, putting their reserves below the required cash minimum. At other times, deposits exceed withdrawals, resulting in “excess reserves,” or cash reserves above the minimum requirement. Banks borrow and lend funds between each other to cover these temporary fluctuations in deposit and withdrawal flows of cash. The rate of interest on the market reflects the availability or “tightness” of such excess funds.

The Federal Reserve can influence this interest rate by purchasing U.S. government securities originating from the U.S. Treasury. However, the Federal Reserve is prohibited by law from directly lending to the U.S. Treasury. Instead, the Treasury borrows money to cover the government’s budget deficit by issuing IOUs –‒ short-term or longer term securities –‒ to financial institutions or larger private lenders. The Federal Reserve then enters the “secondary market” and buys securities held by financial institutions or individuals with newly created money. This cash enters the banking system when sellers of those government securities deposit the payments into their bank accounts. The banks receiving this new money now have larger cash balances with which to extend loans. Banks then lower the rates of interest on loans in order to attract borrowers and lower the rates on short-term Federal Funds for loans to financial institutions under the cash minimum. The result is called “easy” money. A low or falling Federal Funds rate and a banking system awash in new cash allows those banks temporarily short of reserves to meet the requirements.

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