The Fed more or less controls interest rates using open market operations, but why?
Why are interests rate not controlled by supply and demand?
2 Answers
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The fed controls interest rates via supply and demand.
The fed directly controls only one rate, the rate at which banks can borrow from the government.
Lowering this rate permits banks to lower the rates they charge while making the same profit. They don't have to do so, but supply and demand says that those banks who do lower their rate can take business away from those which don't, so the market pressures them to more-or-less follow the fed rate's shifts.
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$\begingroup$ Right, so the banks are 'pressured' into following the Fed's shift. I assume when you say "borrow from the fed" you mean using the fed as a lender of last resort? So, in essence then, as the biggest supplier in the market, if that fed changes the interest rate at which money can be borrowed from it, then the other banks have to follow suit? $\endgroup$– cph2117Commented Oct 3, 2015 at 3:53
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1$\begingroup$ @cph2117 the interest the fed charges is the banks' cost of money. Consider money as a raw material, consumer credit as the end product. Compare it to any other end product. Your raw material becomes cheaper and you're selling product every other guy on the block sells. If you don't lower the price to reflect the reduction of your costs - someone else will, and the business will go to them instead of you. $\endgroup$– littleadvCommented Oct 3, 2015 at 6:42
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1$\begingroup$ A couple of things. First, I don't think this answer actually answers the question. The question isn't how the fed controls interest rates, it's why. Yes, it's to permit banks to lower rates they charge, but why does the fed want that? Second, although the fed controls rates via supply and demand, it does so to make the effective rate match the target rate. Reading between the lines, I think the poster's really asking, why does the fed do even that? The effective federal funds rate is set purely by open market forces (banks borrowing from each other), why not leave it at that? $\endgroup$– blmCommented Oct 3, 2015 at 7:03
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The Fed doesn't control interest literally. They attempt to influence the rate banks charge each other for short term loans using the "open market" to inject and take away reserves.
Why does the Fed overshadow this particular segment of the economy (which granted correlates somewhat with other interest rates)?
It's all about propping up the banking system. Inflation/growth...they will claim these goals are important, but in practicality the Fed's primary worry is making sure the banking system doesn't melt down. It's a legit worry. Banks operate by mismatching short term low yield debt with long term high yeild assets. An inherently insolvent situation in the aggregate that requires constant indirect bailing out from the Fed.
The Fed has determined that targetting the Fed Funds Rate is the best way to do this. It didn't use to be this way. They used to target the discount window early in the 20th century. Out of fear that primary dealers were churning the open market (they are), they tried targetting M1 (should have been M3) during the Volker years in the early 80's. But ultimately the Fed has preferred Fed Funds targeting as it seems to reduce volatility in the banking system (but increases aggregate risks and inflation).
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$\begingroup$ Actually pretty much all central banks have price stability set as their main goal. That seems to conflict with what you are saying. The times where they directly intervene in the banking sector are exceptions. Any basic book on monetary economics will explain how the interest rate is related to inflation. Thus, the interest rate is the instrument with which inflation is controlled. $\endgroup$– HRSECommented Nov 24, 2015 at 4:22
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$\begingroup$ Public goal, yes. But in reality, the prime goal of all central banks is to prop up the banking system. Everything else is secondary. It is not true they rarely intervene into the banking system...they do so ALL the time. The discount window is such a mechanism. But really the primary way in which they do so is the open market which provides artificial liquidity guarantees to the banking system allows them to take risks they normally wouldn't. $\endgroup$ Commented Nov 24, 2015 at 13:56