How the Fed Sets Interest Rates

The role of the US Federal Reserve, referred to most as “the Fed,” and how it determines interest rates remains a mystery for many people. One of the many functions of the Fed is setting short-term interest rates. During my nearly 10 years at the Fed as a Bank Examiner, bankers frequently asked me whether the Fed was going to raise or lower rates. My response always included the same disclaimer: the Fed analyzes and makes decisions based on the same economic indicators that everyone else has access to.

So, what factors impact whether the Fed decides to intervene to stabilize the markets? The Fed sifts through huge amounts of data (known as economic indicators) from various government and non-government sources, which are used to determine the current “health” of the economy. The Fed relies on three types of economic indicators: leading, lagging, and coincident. Leading indicators are used to predict future economic events while lagging indicators are events that have already occurred, but are still important to consider. Coincident indicators measure changes in the economy as they are taking place. Below are some of the key economic indicators commonly used by the Fed to determine interest rates:

• Consumer Price Index (CPI): The Department of Labor’s Bureau of Labor Statistics produces the CPI, which accounts for the change in prices of many goods and services. It is also the most widely accepted measure of inflation and plays a large role in setting and adjusting incomes and other payments. For example, cost of living adjustments, Social Security benefit adjustments, and many other government payments are all based on the CPI. The CPI is published monthly and is considered a lagging indicator because it is based on past events.

• Gross Domestic Product (GDP): The Department of Commerce’s Bureau of Economic Analysis compiles GDP, which measures the value of all the goods and services produced by a given country. It is similar to a person’s annual salary and is used to gauge a nation’s economic power and wealth. GDP numbers are closely monitored by the Fed because GDP value dictates whether a country is in recession or expansion. GDP numbers can also have a big impact on the health of the stock market. Curious how the US GDP compares to other nations? In 2011, the US GDP was $15 trillion whereas the GDP of Russia and China were $1.86 trillion and $7.3 trillion, respectively. GDP is published quarterly and is also considered a lagging indicator.

• Unemployment: Every month the Bureau of Labor Statistics conducts the Current Employment Statistics (CES) survey to assess employment in the US. The Fed keeps a close eye on unemployment figures to measure the impact of their policies. If unemployment remains high, the Fed may decide to initiate more stimulus.

• Stock Market: To the Fed, the stock market is one of the most telling indicators because stock prices are based on future earnings of a company, not its current or past performance. Some economists believe the stock market is an indicator of how the economy will behave six months hence. Trends in the stock market can also provide clues on consumer spending behaviors, as well as, business investments.

There are a multitude of other key indicators, such as retail sales, consumer confidence, new building permits, etc., that factor into the Fed’s assessment of the US economy. In fact, there was a recent Bloomberg news article about how aggregate Google searches can also be used as a leading economic indicator because it represents current hot topics. The Fed considers all these factors (excluding Google searches) when deciding how to set interest rates.

Despite some criticism of how the Fed reacted to the most recent Great Recession, I think Ben Bernanke, current head of the Fed, deserves credit for his commitment to transparency and communicating the reasoning behind the Fed’s actions. Bernanke’s predecessor, Alan Greenspan, was notoriously confusing and often frustrated the public with cryptic speeches, secretive actions (remember Long Term Capital Management?), and infamous buzzwords like “irrational exuberance.” During the Greenspan era, experts were typically interviewed after every Greenspan testimony (the Fed didn’t give press conferences at this point) to decipher his remarks. Sometimes it seemed that Greenspan went out of his way to leave people scratching their heads.

Whether you agree with Bernanke and the Fed’s response to the Great Recession or not, we should all agree that Greenspan’s habits of addressing today’s problems with backdoor deals and obtuse speeches that rattle markets, are a welcome thing of the past.