How The Federal Reserve Affects Interest Rates

Former congressman Ron Paul for several years introduced legislation requiring an audit of the Federal Reserve Bank. Every other corporation in the country is expected to undergo regular audits to ensure investors that they are being managed according to normally accepted financial principles and that the financial statements they publish are true and accurate.

Not so with the Federal Reserve Bank (the Fed). This private corporation, chartered by the U.S. Congress, the only institution allowed to create and destroy money, exercising greater power over the national economy than any other entity, is left to its own devices to remain completely private and un-audited.

In a previous article I gave a brief explanation of how the Fed creates money. In this installment I’ll address how the Fed influences (some might say manipulates) interest rates and why that matters to you.

First, let’s define some terms

  • Federal Funds rate: the interest rate banks charge each other for overnight loans to meet reserve requirements.
  • Discount rate: the rate of interest paid by banks and other financial institutions within the Federal Reserve System to borrow overnight reserve funds from the Federal Reserve.
  • Prime rate: the rate of interest charged by lenders to their most credit-worthy customers.
  • Reserve requirement: the amount of money the Federal Reserve requires banks and other financial institutions to hold, expressed as a percentage of total deposits, at the end of each business day to ensure bank liquidity.

By changing these rates the Fed affects the availability and cost of credit within the entire economy. Money, as a commodity, has a price, called interest. When the price and availability of money are changed, the public’s willingness and ability to pay for goods and services is subsequently changed.

The amount of money that circulates in the U.S. economy increases or decreases when the Fed purchases or sells government bonds and other securities. This affects the federal funds effective rate. The Fed can also influence this rate by raising or lowering the discount rate. Further, by changing the reserve requirement the Fed can influence the amount of money member financial institutions have to lend.

Why it matters

Since the economy virtually runs on borrowed money (business loans, home loans, auto loans, credit cards, etc.), the power to affect total lending affects the economy in a significant way.

The Fed Board of Governors believes itself wise and prescient enough to evaluate American and even world economic variables and make decisions on interest rates and money supply that will maintain a smooth-running, predictable economy, supposedly with the interests of the American public in mind. We won’t go into whether your and my interests are actually what they are concentrating on, but setting financial conditions that affect the billions of decisions made by hundreds of millions of Americans and even billions of the planet’s citizens is a fool’s errand by any calculation.

The Fed affects wages and jobs by manipulating the Federal Funds rate. Increasing the rate tends to slow the economy, which in turn negatively affects hiring. Employees also have reduced leverage to demand increased pay.

Predominantly, credit cards charge variable interest rates based on prime rate, which, in turn, is based on the Federal Funds Rate. Higher credit card rates, especially in an economy so dependent on their use negatively affects consumer spending.

Banks pay interest on deposits, and pay a higher rate of interest if the depositor agrees to leave their money on deposit for an extended length of time. Longer time periods normally result in higher interest. Certificates of deposit are are long-term deposit instruments that many people rely on for interest income. Their rates for the most part are determined by short-term interest rates that track the federal funds rate. But if that rate is kept extremely low, as it has been by the Fed for the last decade, CDs will pay so little as to make them virtually worthless as sources of interest income.

The federal funds rate mainly affects short-term interest rates, but it also affects medium-term fixed loans, such as auto loans. Most auto loans are tied to the prime rate and the auto industry is a major driver of the U.S. economy; increases or decreases in the Fed funds rate, which affects the prime rate, can have a major effect on the financial state of the nation.

So it is with mortgage rates. The real estate industry is as much a mover of the economy as autos. A slight change in the Fed funds rate, which affects the prime rate, which in turn is the main index of mortgage rates has a huge influence on economic activity.

Conclusion

That the Fed has never been audited in its 105-year history is a travesty. That the United States even has a central bank, owned by private shareholders for their own benefit, that has such an overarching effect on the entire nation and influence on the planet should be seen as criminal.

We have been led to believe through government education that there is no alternative to the existence of a central bank. Ron Paul explains why this is not true in the book linked below. If you're more of a video type of person, here's an interesting video on Youtube.

End the Fed by Ron Paul

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