The Federal Reserve and Interest Rates

Treasury Bonds

I always seem to be forgetting this.

Treasury bonds (T-bonds) are fixed-rate U.S. government debt securities with a maturity range between 10 and 30 years.

Key points:

• T-bonds pay semiannual interest payments until maturity, at which point the face value is paid to the owner
• Along with Treasury bills, Treasury notes, and Treasury Inflation-Protected Securities (TIPS), Treasury bonds are one of four virtually risk-free government-issued securities
• Issued by the US Department of Treasury to finance government spending activities
• T-bonds are backed by the U.S. government, and the U.S. government can raise taxes and increase revenue to ensure full payments

Important: Treasury bonds have nothing to do with the central bank and don't play a role in setting interest rates.

However, if inflation surpasses the treasury interest rates, they cease to have returns, and the government loses ability to sell them.

How the Fed Sets Interest Rates

The Fed is what determines the interest rate, but not via bonds:

Fed Funds Rate

The Fed sets target interest rates at which banks lend to each other overnight in order to maintain reserve requirements—this is known as the fed funds rate.

Discount Rate

The Fed also sets the discount rate, the interest rate at which banks can borrow directly from the central bank.

The discount rate is generally set higher than the federal funds rate target because the Fed prefers that banks borrow from each other so that they continually monitor each other for credit risk.

Effects of Rate Changes

When the Fed Raises Rates

• Increases the cost of borrowing
• Makes both credit and investment more expensive
• Can be done to slow an overheated economy

When the Fed Lowers Rates

• Makes borrowing cheaper
• Encourages spending on credit and investment
• Can be done to help stimulate a stagnant economy

Impact on Consumers

Lower rates:

• Banks can borrow from the Fed at less expensive rates
• Banks pass savings to customers through lower interest rates on personal, auto, or mortgage loans
• Creates an economic environment that encourages consumer borrowing
• Leads to increase in consumer spending while rates are low
• Downside: Reduction in interest rates on savings vehicles (CDs, money market accounts)

Higher rates:

• Lending to consumers may be tightened
• Consumer spending shrinks
• Upside: Consumers more likely to receive more attractive interest rates on low-risk savings vehicles

Reference

• Investopedia - Money Market