The Fed's Strategy for Raising Interest Rates

The reasons and impacts of the Federal Reserve's interest rate hike are overwhelming, but few can truly explain the specific operating principles behind it. Most of the news gives us the feeling that the process of the Federal Reserve's interest rate adjustment is particularly simple. He held a meeting and said that setting the interest rate as much as possible is the same. However, many of us are actually unaware that this process is very interesting and complex. There are over five types of interest rates involved, and these methods of interest rate adjustment have also undergone significant changes in history. I believe that understanding the specific principles and historical evolution of the Federal Reserve's interest rate adjustment is crucial for every investor, as it involves many important concepts that we often see but may not necessarily understand. By understanding this topic, you can largely understand the core foundations of the contemporary financial system.

There are many different interest rates in our lives, such as mortgage rates, car loan rates, credit card rates, commercial loan rates, etc. However, these are not adjusted by the Federal Reserve. The Federal Reserve adjusts an interest rate called the final lending rate, which is called the federal funds rate in Chinese. It is the interest rate that banks borrow from each other. So this type of lending is a very short-term loan, often only borrowing for one night, so its interest rate is also called the overnight interest rate, or the interbank overnight lending rate.

That's right, let's talk about the final lending rate today. Generally, people have the following three major issues: Firstly, why do banks borrow money from each other? Secondly, what kind of money is borrowed between banks? Third, since this is the final lending rate, why does the Federal Reserve say the final interbank lending rate? What exactly is the method used by the Federal Reserve to control this interest rate? To answer the first two questions, we must understand the relationship between ordinary commercial banks and central banks, which is an important prerequisite for our understanding of the Federal Reserve's interest rate adjustment mechanism.

The relationship between commercial banks and central banks is similar to the relationship between ordinary people and commercial banks. The money that each of us mainly owns is actually in two forms. The first is the paper currency or coins held in our own hands. The second type is to place it in the form of electronic bookkeeping in the bank. Deposit here. That is a similar situation for commercial banks. Most of the banknotes and coins owned by commercial banks are stored in their own safes, while the remaining money is electronically deposited into their deposit accounts at the central bank. The central bank is equivalent to a commercial bank's bank, and each bank's account at the central bank is called a reserve account. This reserve account is actually very interesting, and we will cover it later in our video. The money deposited by these commercial banks into the central bank is called reserve, which is translated as reserve. That's because these reserves are held in the Federal Reserve's reserve account, so they are also called deposits. The money borrowed between banks is the final lending rate, or federal funds rate.

For convenience of expression, we will abbreviate it as FFR. Why do banks borrow from each other at this final lending rate? There are two main reasons for this explanation: one is superficial, and the other is essential. Let's start with the superficial reason that most people understand. Many countries require commercial banks to deposit a certain proportion of their corresponding customer deposits into the central bank's account to ensure that the bank can meet the customer's withdrawal needs. So this ratio is the reserve ratio we often hear about. The reserves that banks deposit in reserve accounts according to this reserve requirement are called statutory reserves. If a bank deposits too much, the excess is called excess reserves.

When a bank finds that its reserves are lower than the statutory requirements, it needs to borrow reserves from other banks to meet this requirement. The borrowed reserve is the excess reserve from other banks. Many people simply explain the reasons for lending between banks as actions taken by banks to meet their statutory reserve requirements. That explanation is actually very superficial, and the reason is very simple. The United States has abolished the requirement for reserve ratio since 2020, so there is no longer the concept of so-called statutory reserve and excess reserve in the United States. But banks still have reserves, and banks are still frequently borrowing from each other. So whether or not there is a requirement for this statutory reserve ratio, the fundamental reason why banks have reserves is to meet the withdrawal and transfer needs of bank customers and ensure the normal operation of the bank. If the reserve is insufficient, the bank will find a way to make up for it, and borrowing from other banks is one of the main methods.

We have answered the first two questions, and now we can answer how the Federal Reserve adjusts this FFR. FFR is the lending rate between banks, so the Federal Reserve does not have the authority to make regulations. So before we can understand the way the Federal Reserve controls this interest rate, we must first understand how banks and banks determine the interest rate of this FFR, which is essentially the price of borrowing money, or the price of money. Like most prices in the economy, FFR is also determined by supply and demand.

We assume that the supply of reserves in the market remains unchanged, and as demand increases, their focus will shift upwards, resulting in an increase in FFR, which in turn will decrease. Assuming that the demand for reserves remains unchanged, the FFR decreases when the supply increases, and in turn, the FFR increases. Isn't this very simple?

How the Federal Reserve Controls Reserve Supply and Affects FF Interest Rates

One of the important responsibilities of the Federal Reserve is to control the money supply in the economy to ensure that inflation remains at an appropriate level. In order to achieve this goal, the Federal Reserve needs to effectively control the supply of reserves, which are essentially bank deposit reserves. So, how did the Federal Reserve achieve this? The following will explain how the Federal Reserve controls reserve supply through its operations and how it affects the Federal Funds Rate (FF rate).

Firstly, it is necessary to understand the essence of reserves. Reserves refer to the deposit reserves held by banks in their accounts, and the Federal Reserve is this so-called "printing money" institution. When the Federal Reserve wants to increase the supply of reserves in the market, it will buy US Treasury bond bonds and other bonds held by banks at a high price and then directly increase the amount of reserves in bank accounts. This process is called printing money because it is actually increasing the money supply. After banks have excess reserves, they can lend them to other banks.

On the contrary, if the Federal Reserve wishes to reduce reserve supply, it will sell these bonds to banks at a lower price to recover reserves, or more precisely, destroy reserves, which is the process of currency destruction. These operations constitute the fundamental principle behind the Federal Reserve's influence on FF interest rates.

In fact, the Federal Reserve's operations are much more complex than this process. The Federal Reserve has two main ways to influence FF interest rates. The first type is direct participation in market operations, also known as open market operations. This decision-making team is called the FOMC (Federal Open Market Committee), and they determine the scale and direction of open market operations.

The second type of method is the use of policy tools. Although the Federal Reserve does not have the authority to set specific levels of FF interest rates, it can control several special interest rates by adjusting them to affect interbank lending rates. The operational methods of the Federal Reserve have also undergone significant changes in different historical periods.

One of the important historical milestones was the 2008 financial crisis, which triggered a series of changes, including historical changes in reserves. Before 2008, the reserve market was a supply-limited market, mainly because the Federal Reserve did not pay interest on reserves at that time, but banks still had to meet statutory reserve requirements. This leads banks to only store sufficient reserves, as additional reserves amount to punitive taxation. But after 2008, the market shifted from scarcity to oversupply.

Firstly, this is due to the Federal Reserve's large-scale quantitative easing (QE) policy, known as printing money to stimulate the economy, resulting in excess reserves. Secondly, the Federal Reserve began paying interest on reserves stored in banks' accounts. These two interest rates are the interest on statutory reserves (IOR) and the interest on excess reserves paid (IOER). Both interest rates are determined by the Federal Reserve, and excess reserves actually have a greater impact on bank lending rates.

Interestingly, the Federal Reserve later set these two interest rates at the same rate, so their essential differences disappeared. In 2021, the Federal Reserve lifted the requirement for reserve ratio, resulting in the disappearance of the concepts of statutory reserve and excess reserve. These two interest rates were merged into "IOERB" (interest on reserve balances). This change makes adjusting interest rates more simple.

To summarize, before 2008, the Federal Reserve mainly adjusted reserve supply through open market operations while assisting in adjusting IOR to control FF interest rates. After 2008, the Federal Reserve mainly controlled IOERB to affect FF interest rates while using reverse repurchase tools to deal with financial institutions without reserve accounts. This new system is called the "supply system" and makes IOERB the lower limit of the FF interest rate. In addition, the Reverse Repurchase Rate (RPR) has become a new bottom for FF rates as financial institutions are more willing to engage in such transactions with the Federal Reserve. This adjustment has shifted the target of FF interest rates from a specific number to a range.

However, the Federal Reserve is currently gradually raising interest rates and reducing reserve supply, so the reserve market may become a supply-shortage market again in the future. Therefore, the way the Federal Reserve adjusts interest rates may change again, although this possibility is relatively small.

Disclaimer: This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by EBC or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.