Federal Reserve: How it works

Richard Timberlake explains in two short paragraphs:

What the Federal Reserve does have is a powerful moneymaking machine that operates through the offices of its New York bank. In activating this machine to raise rates, the Fed’s decision-making board, the Federal Reserve Open-Market Committee (FOMC), issues a directive to the bank’s account manager to sell more or buy fewer government securities in New York’s financial market. This time the directive was to buy fewer. Since the Fed is a major player in the government securities market, when it buys fewer securities it causes the price to fall and their interest rate to increase.

Unlike anyone else who buys something in markets, a Federal Reserve purchase is not made with old money but with brand-new money. The Fed creates the means of payment. If the seller of the securities wants cash, the Fed uses its authority to print new Federal Reserve notes. If the seller wants a check, the Fed account manager has the authority to issue one that becomes new bank reserves when deposited. Since the Fed creates new currency and bank reserves to purchase government securities, the securities are perforce monetized. They are no longer outstanding debt, but by the alchemy of central banking have been converted into money. Likewise, when the FOMC sells securities or buys fewer than it had been buying, as in this case, the quantity of money in the economy is reduced or its rate of increase is slowed.

And this paragraph explains how a decision to "raise interest rates" is put into action . . .

The action on July 1 called for the account manager to buy fewer securities until the Fed funds rate rose from 4.75 to 5 percent. “Fed funds” are the loans banks make to each other for a 24-hour period. Some banks need extra reserves, others have excess reserves. The Fed funds market resolves these asymmetries. Since Fed funds are an important segment of the reserves commercial banks need to carry on their lending and investing business, any central bank action that constrains reserves raises that particular interest rate.

Timberlake also shows, by quoting real interest rates, that the Fed has only a very limited power to impact these rates, and can do so only by fostering a perverse and pervasive inflation.