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How does the Fed raise interest rates?

Janet Yellen
Joshua Roberts | Reuters
Janet Yellen

When interest rates start rising in the U.S., it will hardly be a surprise.

Officials at the Federal Reserve have been warning for a year that the move is coming. But how, exactly, does a central bank like the Fed raise and lower the price of money?

When a supermarket wants to raise the price of a can of tuna fish, it just sends someone around to print new stickers and slap them on the cans. Gas prices go up and down so often that many outlets have installed electronic signs to change the numbers with a few keyboard licks.

Changing the amount borrowers pay and lenders collect is a little trickier.

Before you get to the "how"—how about explaining "why" the Fed wants to raise rates. Isn't cheap money good for everyone?

It's good for borrowers. That's why the Fed has been having a giant money sale since late 2008 when the bottom fell out of the global financial system. Since then, cheap dollars have flooded through the mortgage market (reviving a dead housing market), the stock market (rebuilding the damage to pensions and 401(k)s) and the bond market (helping companies and governments save money by refinancing their debts at much lower rates.)

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Cheap money is not good for savers, though. (That may be one reason so many people have put aside enough for retirement.) And now that the U.S. economy seems to be back on its feet, and employers are hiring, the Fed figures it's time to end the Money Sale and let interest rates float back up gradually

How does it do that?

The first thing it did was to end its roughly $3.5 trillion shopping spree for Treasury bonds, mortgage-backed securities and other paper left behind by the lending binge that inflated the U.S. housing bubble.

A 10-year Treasury bond is just a 10-year loan to Uncle Sam from an investor. So interest rates on that 10-year loan are set by the market; rates rise when there are fewer buyers and fall when demand is stronger.

When it buys bonds, the Fed also pays cash to the sellers, which pumps money into the financial system and the economy. That cash is created with each new bond the Fed buys. (It doesn't actually "print money"; the number of paper dollars in circulation has no impact on interest rates.)

Once the Fed started buying every bond that wasn't nailed down, rates dropped to low single digits and stayed there. Now that the Fed has ended its bond shopping, rates are expected to begin rising again. So far that hasn't happened. But in the past, when the Fed wanted to raise long-term rates, it started selling some of its bond holdings.

Raising long-term rates, though, only raises the cost of long-term borrowing, like mortgages or bonds sold by corporations or local governments to raise money or pay off higher-rate bonds.

So what about short-term rates?

For that, the Fed has a more immediate mechanism handy in its role as the overseer of the nation's banking system. It's called the federal funds rate.

That's the rate banks charge each other for very short-term loans, usually overnight. The Fed can change that rate with a simple announcement at a moment's notice, though these days it's giving everyone plenty of advance warning. And, when it finally moves, it's expected to raise that rate in baby steps.

But why are banks lending money to each other overnight?

Because they are required to end the day with a minimum amount of capital to cover the loans they've made to consumers: car loans, credit cards, etc. That capital base moves up and down as you deposit your latest paycheck or use your credit card when you go out to dinner. If one bank comes up a little short on cash, it can borrow from another one (electronically, of course) until it opens the doors the next morning and its capital base starts bouncing around again.

By changing the rate on what banks charge each other for those overnight loans, the Fed has an immediate impact on the interest rates banks charge you. That change moves through the economy quickly.

The Fed sets another bank rate called the discount rate, which is what it charges banks to borrow directly from the Federal Reserve system. But banks have lots of other sources of ready cash (starting with other banks), so change in the discount rate usually has a much smaller impact.

The exception is in times of crisis, when the financial system is in trouble and banks have trouble borrowing elsewhere. That's one of the main reasons the Fed was created 100 years ago, to be the lender of last resort.