How do central banks set interest rates?

Central banks do not simply dictate every interest rate. A policy committee chooses a target for a short-term rate, and the bank then uses its own tools to push market rates toward that target. In the United States, the Federal Open Market Committee (FOMC) sets a target range for the federal funds rate, which is the rate banks charge each other for overnight borrowing. Changes in that rate spread to other short-term rates and, through them, to household and business spending. [1] [2]

The FOMC has eight regularly scheduled meetings a year and announces decisions at 2 p.m. Eastern Time on the second day. It consists of the Board of Governors, the president of the New York Reserve Bank, and four of the other eleven Reserve Bank presidents, who serve rotating one-year terms. All twelve presidents attend and take part in discussions, but only the current members vote. [1] [3]

The Federal Reserve Act directs the Fed to promote maximum employment, stable prices and moderate long-term interest rates, commonly called the dual mandate. When demand is weak, the FOMC can ease policy by lowering rates. When demand is too strong and inflation can rise, it can tighten by raising them. The IMF notes that many central banks in advanced economies set explicit inflation targets, and that many developing countries are moving that way. [3] [2]

The Fed steers the federal funds rate mainly through administered rates, meaning rates it sets directly. The primary one is the interest paid on reserve balances that banks hold at the Fed. Because that is a risk-free return, a bank has little reason to lend at a lower rate, so it acts as a floor. [4] [3]

Not every institution in the federal funds market can earn that interest, so the Fed also offers an overnight reverse repurchase facility to a broader set of large institutions. This supports the floor. The discount rate, charged on loans from the Fed's discount window, acts as a ceiling because banks are unlikely to pay more elsewhere than the Fed charges. The Fed usually moves all three rates by the same amount at the same time. [4]

Open market operations are the Fed's purchases and sales of government securities. A purchase is paid for by crediting a bank's reserve account, so these operations change the amount of reserves in the banking system. The administered rates work well when reserves are ample, and the Fed uses open market operations periodically to keep reserves at that level. The IMF describes the more traditional approach, in which central banks adjust the money supply through open market operations to move short-term rates. An Iowa State economics page notes that this older approach no longer works for the Fed, which instead pays interest on excess reserves or conducts overnight reverse repurchase agreements. [4] [2] [5]

The detailed mechanics above describe the United States. Other central banks use their own frameworks. A Norges Bank speech in the results says central banks also influence rates through communication, such as publishing an interest rate path as a form of forward guidance, but the excerpt provided does not give enough detail to describe it further. [6]