This column is to appear in the Augusta Business Chronicle (May 2001). Does the Fed Set Interest Rates? No. Now that the hoopla about the Federal Reserve Bank's cutting interest rates has died down a bit, it's time to correct some misconceptions. Foremost among those is the notion that the Fed actually cuts or raises interest rates. Nonsense. The Fed does no such thing. Here is what the Fed does. The seven Federal Reserve Bank governors (actually, five since there are two vacancies) meet with the 12 regional Fed presidents roughly every six weeks in what is called the Federal Open Markets Committee (FOMC), although only 5 of the 12 regional presidents have voting rights at the meetings (the voting right rotates every year). Mr. Greenspan presides. The FOMC members consider the state of the economy and their legal obligation to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." In practice, though, the Fed's first order of business is price stability, i.e., ensuring relatively low rates of inflation, safeguarding the value of your money, the dollar. Obviously, the Fed cannot directly determine employment, nor can it dictate prices. Neither can it directly "set" long-term interest rates. It can merely influence the direction in which interest rates move (up, down, or unchanged).  Here's how the Fed, or rather the FOMC, does it. At the FOMC meeting, the members determine the extent to which the Fed, via its New York City branch, should enter the open market for bonds (IOUs) or other securities, either buying from those who wish to sell or selling to those who wish to buy. These securities are issued by public agencies (such as the US treasury) or private companies, and include international (i.e., foreign governments and companies) IOUs.  When the Fed buys a $100 million IOU that, say, Bank of America, wishes to sell, the Fed has the convenient option of paying for it literally by printing the money (or, in practice, by crediting BoA's account at the Fed). Initially, nothing has changed in the balance sheet of BoA, except that instead of having $100 million worth of assets in the form of an IOU it now has $100 million more in cash reserves. But whereas the IOU earned interest, cash reserves do not. Therefore, BoA -- a for-profit private company after all -- is under pressure to loan out the $100 million cash. But in a competitive global financial market, the best way to loan out additional cash reserves is of course by charging a relatively low interest rate. So, yes, there is definitely a link between Fed policy and interest rates. But the Fed does not tell Bank of America what interest rate it should charge on the $100 million cash reserves to be loaned. That is the job of BoA's managers. Therefore, the Fed does not "set" interest rates. It merely "influences" them by making more (or fewer) cash reserves available. For example, suppose that Bank of America does sell its IOUs to the Fed but then finds it difficult to convert the $100 million cash reserves into loans. Then BoA will need to offer interest rates below what it intended, and therefore market rates will fall below what the Fed intended. Just because cash reserves are available does not mean that you and I will have to borrow from the bank. We see that in practice the Fed's task is rather more complex than the news media make it appear. It does not simply "set" interest rates. Instead, it targets a desired interest rate (the so-called Federal Funds rate) and then daily intervenes in the private (open) market for bonds and other securities in an attempt to hit the target. This goes on to the tune of billions of dollars each day. The science of how the Fed influences interest rates is fairly straightforward; the practice, however, is an art. Dr. J. Brauer is Professor of Economics at Augusta State University's College of Business Administration. He can best be reached via his web site (http://www.aug.edu/~sbajmb).