Perhaps no institution has more power to affect the nation's economy than the Federal Reserve, the independent central bank established by Congress in 1913. Under the leadership of its influential chairman, Ben Bernanke, the Fed steers the economy most directly by periodically raising and lowering the federal funds rate, which banks charge to each other on overnight loans. Such rate changes can take six to nine months to work completely through the economy.
While Fed policy changes frequently are attributed to the central bank's Chairman, Ben Bernanke, decisions actually are made by the Federal Open Market Committee. The Federal Open Market Committee consists of twelve members: the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and, for the remaining four memberships, which carry a one-year term, a rotating selection of the presidents of the eleven other Reserve Banks. The FOMC holds eight regularly scheduled meetings per year to direct the conduct of open market operations by the Federal Reserve Bank of New York in a manner designed to foster the long-run objectives of price stability and sustainable economic growth. The FOMC also establishes policy relating to System operations in the foreign exchange markets.
Through its interest rate adjustments the Fed attempts to guide the economy. But, what is the actual effect of these actions?
When rates go up -
Raising interest rates is considered an effective way to quell inflation. The Fed will raise rates to keep the economy from overheating.
Businesses: Higher interest rates make it more difficult for businesses to get loans to expand. Unemployment tends to rise, which eases wage inflation, although at a human cost.
Consumers: Higher interest rates on credit cards and mortgages can cool consumer spending, which accounts for about two-thirds of economic activity.
Markets: Higher interest rates tend to attract investment into bonds and other fixed-income investments, pushing down stock prices.
When rates go down -
The Fed generally cuts interest rates when inflation is subdued and the economy needs a boost.
Businesses: Lower rates cut the cost of capital, improving profit margins and encouraging expansion.
Consumers: Lower interest rates can create economic activity by inducing consumer spending. For example, lower mortgage rates can spark home sales and mortgage refinancing. But the Fed's ability to affect such long-term rates is indirect.
Markets: Lower interest rates tend to boost stock prices because bonds and other fixed-income investments are no longer so attractive. In addition, lower rates cut costs for companies, boosting profits.