Who Sets Interest Rates? (Simplified for the General Public)
Researched and Written by Mike Zschunke, Scottsdale, AZ, June 2025
In the United States, the Federal Reserve, often called "the Fed," is in charge of setting a “target” interest rate called the Federal Funds rate. This is the rate banks charge each other to borrow money overnight. It’s a big deal because it affects borrowing costs for things like mortgages, car loans, and credit cards across the economy.
The Fed doesn’t set the exact rate banks use—it sets a target range and uses tools to guide the actual rate (called the Effective Federal Funds Rate ) to stay within that range.
The Federal Open Market Committee (FOMC), a group within the Fed, makes these decisions. The FOMC is led by the Fed Chair (currently Jerome Powell) and adjusts the target rate based on how the economy is doing—like managing inflation, job growth, or economic slowdowns.
Around the world, other countries have their own versions of the Fed, like the European Central Bank (ECB) for Europe or the Bank of England (BOE) for the UK. Each sets interest rates for their country to keep their economies stable. The United States is often recognized as the World Leader and often considered a flight to safety in turbulent times.
How Does the FOMC Achieve Its Target Rate?
The Fed uses a few key tools to make sure the actual federal funds rate stays close to the target range they set. Here’s how they do it in simple terms:
Buying or Selling Bonds (Open Market Operations): The Fed buys or sells government bonds to control how much money banks have to lend.
***Buying bonds puts more money into banks, increasing liquidity and making it easier to borrow and lowering the interest rate.
***Selling bonds takes money away, decreasing liquidity and making borrowing harder and raising the rate.
Paying Interest on Bank Reserves (IORB): The Fed pays banks to keep money at the Fed. This payment sets a “minimum” interest rate.
Banks won’t lend to each other for less than this rate because they can earn it risk-free by keeping money with the Fed.
Short-Term Loans to Banks (Repo Operations): The Fed lends money to banks for a short time using bonds as collateral. This adds extra cash to the system, helping keep the interest rate from going too high.
Borrowing from Others (Reverse Repo Operations): The Fed borrows money from non-banks (like money market funds) to take extra cash out of the system. This prevents the interest rate from dropping too low.
Emergency Loans (Discount Window): Banks can borrow directly from the Fed at a slightly higher rate. This sets a “maximum” rate, as banks prefer to borrow from each other at lower rates unless they’re desperate.
Together, these tools act like a thermostat, adjusting the amount of money available to keep the federal funds rate close to the FOMC’s target. The New York Fed handles these day-to-day adjustments to make sure everything stays on track.
Who Makes Up the FOMC? (Simplified)
The FOMC has 12 voting members who decide on the federal funds rate and other policies. Here’s who they are:
-Seven Federal Reserve Governors: These are people appointed by the U.S. President and approved by the Senate. The group is led by the Fed Chair, currently Jerome Powell.
-President of the New York Federal Reserve Bank: This person always gets a vote because New York is a major financial hub.
-Four Other Federal Reserve Bank Presidents: There are 12 regional Fed banks (like in Atlanta, Chicago, or San Francisco), and four of their presidents take turns voting each year.
Non-Voting Members: The other seven regional Fed bank presidents attend meetings and share ideas but don’t vote.
The FOMC meets about Eight Times per year to review the economy and decide whether to raise, lower, or keep the target interest rate the same.
“The next time you hear someone say the Fed should simply raise or lower interest rates, remember it’s not that straightforward. Setting the federal funds rate involves complex decisions by the FOMC, using tools like bond transactions, reserve interest, and short-term loans to balance the economy. These careful calculations help manage inflation, employment, and growth, ensuring the U.S. economy stays on track.” – Mike Zschunke, Scottsdale, AZ, June, 2025