eli5 Where does all the extra money from fed interest rate hikes go?

Question

Especially regarding mortgage rates- folks are paying huge increases in monthly payments.
I’m assuming “to the government” but does it just get held somewhere?

In: 67

Answer 1

The answer is to banks with extra cash.

In order to stop banks from lending out a million dollars for every dollar in deposits they have, they set a hard limit of 10x assets. If your bank has 100 dollars in all savings, checking, CD, etc accounts and makes a loan for 1001 dollars they will be shut down. The Fed further controls inflation by paying the banks interest on any amount UNDER the 10x limit that’s the Fed interest rate. It’s the rate the Fed will pay a bank to NOT make loans.

When you go to a bank to get a mortgage, the bank only has so much money they can lend. They must choose between lend a dollar to you, with a risk of not getting it back, or keep the dollar and get an interest payment on it from the Fed. That’s why mortgages and other bank loans are at the Fed interest rate PLUS some amount based on how risky the loan is.

Raising the Fed rate means banks become less likely to issue loans because they have to be pickier about what they fund. The small business selling bunt cakes on the corner can only reasonably generate enough profit to pay a 2% interest loan, when the Fed rate was 0% it made sense for the bank to make that loan. When the Fed rate goes above 2%, the bank won’t make that loan because they’d get more interest payments with less risk from the Fed instead.

So you’re thinking about it backwards. The Fed interest rate is the amount of interest the Fed is willing to pay, not what they charge on loans they issue.

Edit: Teeeechnically what I described is the interest rate on reserve balances (IORB) which is what the Fed interest rate is tied to and what the Fed can directly control. The actual Fed interest rate is the target rate the Fed wants (but can’t require) private banks to charge each other. They use the IORB, which they do control, to get the banks to hit the target rate. When the Fed raises rates, they’re simply issuing a new target they want the private banks to hit, raising the IORB is how they actually make it happen.