The Federal Reserve Bank (Fed) uses a variety of instruments to manipulate unemployment, inflation, and other business cycles.
But of all the financial instruments at its disposal, the Fed’s ability to raise or lower interest rates is likely to be the most influential. And it is certainly the Fed’s monetary policy that is discussed the most by the media and the general public.
The federal funds rate has been close to zero since March 2020 when the COVID pandemic and widespread lockdowns first caused a financial crisis. Currently, Fed officials say interest rate hikes are not expected until 2023 at the earliest. However, that schedule could change depending on how the economy performs over the coming months.
Why does it matter if the Fed hikes rates? How could it affect inflation, savings rates, mortgages, and other types of financial products? Here’s what you need to know.
Understand economic cycles
Economies are subject to boom and bust cycles. Economies grow and grow until an event occurs that leads to bankruptcy, and then the cycle repeats itself. These can be easy or difficult, as was the case with the Great Financial Crisis (GFC) in 2007/2008. To understand why it is important for the Fed to raise interest rates, let’s first look at what is causing the economies to expand and contract.
An expanding economy is one that is growing. In an expanding economy, jobs are created (unemployment falls), people spend, and GDP rises. At some point the economy inevitably peaks and growth begins to slow down. The slowed growth doesn’t mean the economy has turned. It means there is still growth but the rate of change from month to month or quarter to quarter is decreasing.
When an economy peaks, consumers have reached their maximum spending and GDP is essentially unchanged. The economy is no longer expanding. Within the economy, companies are likely to have raised prices as much as possible (ie, demand has flattened). And as consumer demand starts to drop due to high prices, prices will eventually drop too.
At the same time, companies can lay off employees due to a lack of demand. During this phase, the economy is said to be in contraction and possibly into recession. Eventually the economy will bottom (i.e. bottom out) and then start expanding again.
These cycles are normal for any economy. However, cycles can overshoot resulting in very high inflation. On the other hand, they can fall below this, leading to a recession or even depression.
The story of the Fed
The United States has not always had a Federal Reserve Bank. Before 1913, reluctance to set up a central bank was due to fear of a consolidated power. Instead of a central bank, the cities had banking associations called clearinghouses. In addition, from 1863 to 1913 the country was part of the National Banking System, a decentralized coalition of banks.
But the economy has seen significant stock market panics throughout United States history, sometimes followed by economic crises. Some notable stock market panics that resulted in a decline in economic activity or even a recession were the panics of 1819, 1837, 1857, 1873, and 1893.
The straw that broke the camel’s back was the panic of 1907. That year the Knickerbocker Trust Company went bankrupt. Panic ensued as bank runs spread across the country. However, people couldn’t withdraw their savings because the banks had no money.
During that time, the stock market fell 50% from its high. There was no post-panic depression. But some businesses were liquidated. A year later, the stock market had almost completely made up for its loss. It was JP Morgan who brought the financial system back to stability.
The country knew, however, that it could not rely on a wealthy financier for every panic. This led to the creation of the Federal Reserve in 1913. It consisted of 12 Federal Reserve banks and was supposed to counteract the ups and downs of the economy and at the same time limit inflation.
The role of the Fed
Since 1977 the Federal Reserve has operated under a dual mandate from Congress. Its job is to promote maximum employment and stable prices (ie to control inflation).
How did the Fed do its job? Well, we had the Great Depression in the early 1930s. But to their credit, the Fed succeeded in curbing runaway inflation in the late 1970s. Many say the Fed saved the US financial system from collapse during the Great Financial Crisis (GFC).
Starting with the GFC, we see the Fed employing quantitative easing measures for virtually every future economic crisis. And yes, that certainly includes the coronavirus crisis that the United States (and the world) are currently experiencing.
Why the Fed is raising or lowering rates
When the economy overheats, the Fed raises rates to hold it back. In an overheated economy, there is full employment with rising inflation and growing GDP.
One of the key factors in an overheated economy is creditworthiness. When credit is too loose, people and businesses can easily spend money. And that means that companies and individuals are often tempted to take on excessive debts. Inflation can also get out of hand – when there’s a lot of money around, prices go up because everyone knows they can ask for more (with all the money floating around).
When the Fed raises rates, borrowing slows down (because borrowing is more expensive). These seep into the economy as loan agreements. It also has the effect of lowering inflation. Spending less means companies will be forced to stop raising their prices or, in some cases, lowering prices in order to compete.
Rising interest rates slow the economy, but can also lead to a recession.
On the other side of the coin, the Fed will cut interest rates to stimulate economic growth. Lower interest rates expand lending because businesses can borrow at lower interest rates.
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Is the economy ready for a higher key rate?
There is a lot of debate about whether the economy is strong and able to keep growing, or whether it is fragile and needs more incentives. The Fed is still throwing massive $ 120 billion a month in incentives on the financial system. That’s $ 40 billion more than during the GFC.
In addition, the government stimulates the economy through direct checks to the taxpayer (stimulus checks) and various fiscal programs, such as the infrastructure program.
But those who say the economy is getting hot point to the unemployment rate of 5.2% as of August 2021. They also indicate that there are many vacancies and that GDP growth and the stock market have hit all-time highs. If we side with those who believe the economy is warming, it may be time for the Fed to consider raising rates.
Potential impact if the Fed hikes rates
In the current economic climate, what could an increase in interest rates mean for companies and individuals? First, the increase in interest rates will limit lending. As mentioned earlier, a decline in lending can also put a brake on an economy.
Mortgage rates are currently very low, which is one reason for the high property prices. An increase in interest rates will increase mortgage rates and slow the rise in house prices.
Looking at the other side of the rate hike argument, inflation just hit a 13-year high. When the Fed raises rates, inflation tends to slow as borrowing decreases. And when fewer individuals and companies get funding, it reduces the amount of money that goes into the economy.
When the annual rate of inflation is lower than the average rise in wages, the cost of living becomes more affordable. And that makes it easier for individuals and families to meet their core needs and save for future goals.
Speaking of saving, higher federal funds rates mean higher interest rates on savings accounts and certificates of deposit (CDs). Before the pandemic, it wasn’t uncommon for some high-yield savings accounts to offer APYs above 2%. But these types of rates have been unknown since the Fed’s first rate cut in 2020.
So what is the Fed going to do? The general consensus is that this year it will begin throttling its bond-buying program. That means reducing bond and mortgage-backed securities (MBS) purchases by $ 120 billion. While this will not increase interest rates, it can cause mortgage rates to rise as the FED’s MBS purchases have a direct impact on mortgage rates.
As mentioned earlier, the Fed does not anticipate a rate hike before 2023 or 2024. However, the International Monetary Fund has warned that this may have to happen as early as the end of 2022 to stave off rising inflation.
Ultimately, the Fed’s decision to raise rates or leave them alone will largely depend on where unemployment and the economy are at that point in time. If the economy is strong until the end of 2022, interest rate hikes can be expected. However, if growth has reversed by then, it is likely that the Fed’s bond-buying program will return in full and interest rates will stay near their current lows.