Does the Federal Reserve Control Interest Rates?

Anyone old enough to have been paying attention to the economy in the early 1980s remembers the Fed Chairman Paul Volcker and his iconic cigar, and what came to be known as the “Volcker Shock”. To combat increasing inflation throughout the 1970s, Volcker began to raise the discount rate when he assumed office in 1979, and continued to raise the rate until it peaked at 14%* by June of 1981. History credits him with bringing down the inflation rate from its high of 14.8% to below 3% by 1983*. The dramatic events of that time have cemented a notion in the public consciousness: The Federal Reserve Controls interest rates. Is this true?

The only rate set by the Federal Reserve is the discount rate. This rate is set by the Fed because it is the rate it charges to member banks when it lends money to them through the “discount window”. The discount window is not intended for regular use. It is there when a bank is experiencing a cash crunch. At any given time, the great majority of banks are solvent, and they borrow from their customers whenever they deposit funds at the bank. In other words, the only rate set by the Fed is the rate on little-used loans to banks that have temporary cash flow problems; hardly a rate that affects the overall interest rate climate or economic activity.

Every time the Fed meets, the public waits with bated breath for the announcement regarding the Fed Funds rate. In reality, the Fed does not control the Fed Funds rate. This is why they speak in terms of a “target range”. For example, as of this writing, the Fed Funds target range is between 4.75% and 5%*. In fact, the Fed does not directly set any interest rate other than the discount rate. That would include all the interest rates that matter: Rates earned on investments such as bonds and cash equivalents, and rates paid on mortgages, car loans, and credit cards. So if these rates are not set by the Fed, by what factor are they determined? In a word, inflation.

Inflation occurs when the money supply is increased by the Fed at the behest of the US treasury, and the result is a devaluation of the dollar, evidenced by an increase in prices. Lenders demand to be compensated for the devaluation of their dollars when they are on loan. As the inflation rate and rate of devaluation rises, interest rates increase to compensate lenders, and when the rate of inflation falls, so do interest rates.

The Fed influences the money supply through open market operations, which is the buying and selling of Treasury and Corporate bonds in the open market. When the Fed buys securities, they release cash into the market, in what is known as quantitative easing. Conversely, when they sell those securities, this removes cash from the market thereby lowering the money supply.

It is ironic that the Fed says it “fights” inflation when in fact, it creates it! Inflation, in turn, moves interest rates. The Fed can announce whatever Fed Funds target range it likes and that announcement can have some temporary self-fulfilling  psychological effect, but it is inflation that moves interest rates over the longer term. We can now see the result of the large increase in money supply that occurred during the COVID era:

FRED Economic Data: M1 Money Supply 

Source: Board of Governors of the Federal Reserve System as of August 2024

The increase in M1 money supply by the Fed in 2020 was unprecedented; rising by nearly 12 Trillion in May of 2020 alone! The result was an inflation rate which increased from below 2% up to over 9%  by 2022**. The increase in inflation caused interest rates to rise dramatically, with most rates tripling and quadrupling within a few short years.

In summary, future interest rates will be determined by the future money supply and inflation, not by any announcements from the Federal Reserve. The Fed is not controlling interest rates, it is controlling the money supply which in turn affects the inflation rate. Lenders demand to be compensated accordingly with interest rates that move with inflation. Fed announcements have little affect; they are merely announcing what is already taking place.

* Source:  Board of Governors of the Federal Reserve System

**Source: a CoinNews Media Group Company; US Inflation Calculator, Consumer Price Index Data from 1913 to 2024