How do central banks impact interest rates in the economy?

The central bank for the United States – the Federal Reserve (the Fed) – is tasked with maintaining a certain level of stability within the country's financial system. Specific tools are afforded the Fed that allow for changes to broad monetary policies intended to implement the government's planned fiscal policy. These include the management and oversight of the production and distribution of the nation's currency, sharing of information and statistics with the public, and the promotion of economic and employment growth through the implementation of changes to the discount rate.

The most influential economics tool the central bank has under its control is the ability to increase or decrease the discount rate. Shifts in this crucial interest rate have a drastic effect on the building blocks of macroeconomics, such as consumer spending and borrowing.

For banks and depositories, the discount rate is the interest rate assessed on short-term loans acquired from regional central banks. Financing received through federal lending is most commonly used to shore up short-term liquidity needs for the borrowing financial institution; as such, loans are extended only for an overnight term. The discount rate can be interpreted as the cost of borrowing from the Fed.

When the Fed makes a change to the discount rate, economic activity either increases or decreases depending on the intended outcome of the change. When the nation's economy is stagnant or slow, the Federal Reserve may enact its power to reduce the discount rate in an effort to make borrowing more affordable for member banks. (For related reading, see: How does the Federal Reserve determine the discount rate?)

When banks can borrow funds from the Fed at a less expensive rate, they are able to pass the savings to banking customers through lower interest rates charged on personal, auto or mortgage loans. This creates an economic environment that encourages consumer borrowing and ultimately leads to an increase in consumer spending while rates are low.

Although a reduction in the discount rate positively affects interest rates for consumers wishing to borrow from banks, consumers experience a reduction to interest rates on savings vehicles as well. This may discourage long-term savings in safe investment options such as certificates of deposit (CDs) or money market savings accounts.

When the economy is growing at a rate that may lead to hyperinflation, the Fed may increase the discount rate. When member banks cannot borrow from the central bank at an interest rate that is cost-effective, lending to the consuming public may be tightened until interest rates are reduced again. An increase to the discount rate has a direct impact on the interest rate charged to consumers for lending products, and consumer spending shrinks when this tactic is implemented. Although lending is not as attractive to banks or consumers when the discount rate is increased, consumers are more likely to receive more attractive interest rates on low-risk savings vehicles when this strategy is set in motion. (For related reading, see: How does a high discount rate affect the economy?)