How Policies of the Federal Reserve Board Set Interest Rates

Congress created the Federal Reserve Board (FRB) in 1913 to regulate the banking industry. The Board is run by a seven-member board of governors. The most important governor of the board is the chairman of the Federal Reserve. The chairman oversees the entire Federal Reserve System, which consists of the board and 12 regional reserve banks. The Federal Reserve System is the central bank of the United States.

The purpose of the Federal Reserve (called "the Fed" for short) is to control the quantity of money in the US economy and maintain the stability of the banking system. The Federal Reserve supervises and regulates all US banking institutions.

The Federal Reserve has a major role in setting United States economic policy. Its policy goals include sustained economic growth, high employment levels, stable prices (low inflation), and moderate long-term interest rates. The Fed conducts monetary policy through the buying and selling of US Treasury securities, setting bank reserve requirements, and setting the rate at which banks are charged for borrowing federal reserves (known as the discount rate).

Low interest rates encourage borrowing and investing, increasing the money supply and therefore prices. In order to maintain stable prices and meet its inflation target, the Federal Reserve can affect interest rates or the money supply. Interest rates can be affected by the Fed changing the discount rate banks are charged to borrow money from the Fed or the federal funds rate that banks charge one another. Banks, in turn, pass on this interest rate change to their customers. To change the money supply, the Fed either sells or buys more Treasury securities.

If the Fed sees that there is a danger of an economic slide, it can lower interest rates or purchase Treasury securities to increase the money supply, which stimulates spending. If the Fed is concerned that the economy is overheating and inflation is rising, then it can increase interest rates or sell Treasury securities to reduce the money supply, which will cool down the economy and reduce inflation.

When the federal government needs to increase its spending, it sells bonds and increases interest rates, often increasing the budget deficit in the process. When the US Treasury buys back the bonds it has sold, it increases the money supply and gives investors more money to invest in other securities. This lowers interest rates and encourages spending.