How Does the Federal Reserve Set Interest Rates?

by Linsay Evans

The Federal Reserve -- also known as the Fed -- has more influence on the United States’ economic growth and employment levels than any other governmental body, according to “The New York Times.” One of the Fed’s most powerful tools lies in its control over interest rates. When the economy is sluggish, the Fed cuts interest rates -- essentially lowering the cost of money -- and raises rates to slow too-rapid expansion.


Until 1863, when the National Banking Act passed, local and regional banks created and circulated their own currency. The act paved the way for the creation of national banks that backed their currency with government securities. Despite the act’s passage, a series of economic panics -- especially the depressions of 1893 and 1907 -- set the stage for even more centralization. While conservatives pushed for a banker-controlled system, progressives advocated for a public-controlled central bank. In 1913, under the leadership of Woodrow Wilson, the Federal Reserve Act created the Federal Reserve and charged it with the responsibility for the U.S.’s monetary policy.


The stated goals of the Fed’s monetary policies, as legislated in the Federal Reserve Act, are to “promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” In addition, the 1946 Employment Act and the 1978 Full Employment and Balanced Growth Act direct the Fed to “promote high employment and economic growth; stable prices or low inflation; and stable financial markets and interest rates,” according to Peter Ireland of Boston College’s Department of Economics.

Prime Rate

The Fed works toward these goals by manipulating an interest rate known as the federal funds rate; low rates tend to indicate a larger monetary supply, while high rates usually signify less flow. These rates influence short-term interest rates and the flow of money through the economy through influencing the prime rate. Banks use the prime rate or base rate when making loans; though the Fed doesn’t set the prime rate, banks generally base it on the federal funds rate.

Open Market Operations

The Fed controls the federal funds rate through a process known as open-market operations. Defined by the Federal Reserve as “purchases and sales of U.S. Treasury and federal agency securities,” open-market operations determine the interest rate at which banks lend to other institutions. The long-term goals of open-market operations manipulations include economic growth and price stability.

Discount Rate

The Fed also determines the discount rate, defined by the Federal Reserve as the rate of interest charged to banks and other depository institutions. The discount rate applies to short-term loans the Fed makes to banks, known as primary credit, secondary credit or seasonal credit. Each type of loan has a separate interest rate, depending on the financial status of the bank taking the loan.

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