What does the Fed raising interest rates mean?
Every six to eight weeks we hear all this about the Fed (really the Federal Open Market Committee) changing interest rates. Some get confused as to what this means, and others just seem to have a weird interpretation. They get these strange idea that the Fed is setting the rate on government debt or something. Those are all set by the market, but here's a quick description of what the Fed actually does.
There is essentially only one rate (and others that are keyed off of it) that the Fed can set by fiat, the discount rate. That is the interest rate the Federal Reserve Bank charges member banks to borrow money overnight. However, this isn't the rate you usually hear being talked about. But it does bring up one important question of why a bank would borrow money just for a single night?
Every day banks need to meet reserve requirements. That is, they need to have part of their deposits covered. Currently that is 10 percent. That means if a bank has $100 million in deposits, it must have at least $10 million to cover potential withdraws. (In practice, this is more complicated. Some types of deposits have no reserve requirements, and smaller banks have lower reserve requirements.) This prevents the bank for taking the $10 I deposited and turning around and loaning it all out to somebody else. It can still loan $9 out, though. If that bank didn't have $10 million to cover its 10 percent of $100 million in people's accounts, it would need to borrow to cover the reserve requirement. It could just go to the Fed discount window and get a loan there from the big man himself.
However, if another bank had some spare money sitting around, they might be willing to loan it out to the bank needing to meet reserve requirements. Basically, they trade reserves between themselves. This is the rate that everbody talks about, and its called the fed funds rate. The Fed cannot really set this rate as it sets the discount rate because it is what private banks charge each other to borrow overnight. However, each bank continuously publishes a chart of at what rate they are willing to loan money to each other. Knowing this, the Fed can try to manipulate the rate.
To push the fed funds rate to the desired target, the Fed manipulates the amount of reserves in the system. With more reserves, there is less borrowing pressure and more lending pressure, and the rate is pushed down. With fewer reserves, the reverse happens; there is less supply and greater demand for them, driving the rate higher.
To adjust the amount of reserves, the Fed undertakes open market operations, buying and selling securities on the open market. When the Fed buys a security, it essentially writes a check against itself. When the bank presents that check to the Fed, it credits their reserves account creating money and increasing the money supply. When the Fed sells a security, it takes the check written against a bank and deducts from their reserve account at the Fed. This decreases the amount of reserves available and the money stock. This way, the Fed can adjust the overnight fed funds rate by playing with the forces of supply and demand of central bank reserves.
The favored security to buy and sell is short-term Treasury notes (those with a maturity of a year or less), but also longer-term Treasury securities. These provide a very liquid market that is always available to enter and exit, and there is no risk involved. Really, anything could be used -- corporate paper, real estate, stock, or the famous dropping dollar bills out of planes to increases the supply of money -- but none of them are nearly as good as Treasurys.
Besides targeting the fed funds rate, the Fed could target something else with open market operations. The quantity of money was big when monetarism was being tried out in the late 1970s and ealy 1980s. Or the price of gold could be targeted for a gold standard.
The effects of changing the overnight interest rate is felt all though the bond markets. As the cost of borrowing money for the bank goes up, so do other interest rates. Beyond that, its hard to come to a concensus on the effect it has on the value of the dollar and for what reasons. The prevailing view is that a higher interest rate will lead to strength in the dollar. With fewer reserves, the dollar becomes scarce relative to goods, and if growth causes inflation, a higher interest rate can abate demand, pushing back inflationary pressure. However, if growth is inherently deflationary (more goods chasing fewer dollars), then it becomes competing forces: there are fewer dollars, putting upward pressure on the dollar, but if growth slows, that would put downward pressure on the dollar.
There really isn't anything in the idea that the Fed needs to raise interest rates to make bonds more attractive to investors. If bonds were not attractive, their prices would fall, driving their yields higher, until a point was found that boths sides of the transaction liked.