How Does the Government Decide Whether or Not to Raise and Lower Interest Rates?

Kathy Deck, director of the Center for Business and Economic Research in the Sam M. Walton College of Business, replies: As the central bank of the United States, the Federal Reserve is tasked with conducting monetary policy to support the dual mandates of price stability and domestic economic growth. One of the most important ways that the Federal Reserve supports the U.S. economy is by setting the federal funds rate, the interest rate that banks use to lend to other banks overnight. Many other interest rates are tied to the federal funds rate, both implicitly and explicitly. A low federal funds rate encourages investment because the cost of money is low. On the other hand, a high federal funds rate discourages new economic activity, as the rate of return that a business generates must be sufficient to warrant borrowing at a high cost. The Federal Open Market Committee is the part of the Federal Reserve that implements monetary policy. When the committee examines the latest data and determines that the economy is weak, lowering the federal funds rate — and by extension, many other interest rates — can provide monetary stimulus to the economy. When the committee observes the economy to be overheated, primarily in terms of unacceptably high inflation or inflation expectations, it may raise the federal funds rate to promote price stability. Since the onset of the latest recession, the Federal Reserve has engaged in a policy known as quantitative easing. Quantitative easing involves the direct purchase of longer term government bonds by the Federal Reserve in an attempt to lower longer term interest rates than those tied directly to the federal funds rate.