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Last Wednesday – 16 March – after two years of keeping interest rates near zero to combat the economic consequences of Covid-19, the Federal Reserve approved its first-rate increase in years. The long-awaited 0.25% rate hike (25 basis points) was announced following the Federal Open Market Committee’s meeting.
The maneuver hikes the federal funds rate to between 0.25-0.5%, with six more rate hikes expected this year. Assuming that each hike represents another 0.25% increase, the federal funds rate is slated to hit 1.9% by December.
During the meeting, Fed also addressed its hefty balance sheet of Treasuries and mortgage-backed securities. Going forward, it intends to relax the quantitative easing programs implemented to buoy financial markets and ease economic panic during the pandemic.
That’s a lot of boring mumbo-jumbos for an article introduction – we don’t blame you if you zoned out a bit. Let’s look at why all those numbers and names matter.
Over the last 12 months, inflation has hit an all-time high (approaching 8%). Some inflation is good – necessary, even – for spurring business growth and wage increases. But when inflation runs too hot, as it’s doing now, consumer prices rise astronomically and unevenly throughout the economy, depending on the specific cause.
There’s not a single, simple explanation for the record-high inflation in the U.S. Instead, several factors are working together to compound an existing problem.
To start, when the economy reopened following Covid-19, many sectors were unprepared for the uptick in demand. Raw materials and manufacturing shortages soon followed, leading to supply chain snaggles. Complex transportation logistics did nothing to quell the problem.
Combine that with economy-wide wage increases, unprecedented levels of economic stimulus, and the impacts of the Russia-Ukraine conflict, and it’s easy to see why inflation is at its highest peak in 40 years.
If High Inflation is So Bad, What Took So Long?
In the early days of Covid-19, the Federal Reserve slashed the funds rate to prop up crumpling markets and the onset of an economic recession. But in the past few months, following easing pandemic restrictions, the Fed has been reluctant to address rising inflation.
In fact, a press release from September 2020 states that the Fed planned to “keep the target range for the federal funds rate” at or below 0.25%. At the time, the central bank intended to let inflation run until “labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment.”
In other words, the Fed recognized that the current inflationary environment wasn’t just boosting employment rates – it was improving employment prospects and wages across race, gender, and wealth in a way that the U.S. hasn’t seen in decades. (If ever.) At the same time, new economic growth was just beginning to spin up, sparking innovation and encouraging the Great Resignation. And, for a time, the Fed’s approach worked as intended…until it didn’t.
Essentially, inflation rose faster and hotter than initially expected. Consumers began to feel the impacts in their pocketbooks as vehicle, energy, and housing prices soared. And evolving world events sparked new supply shortages, threatening to boost inflation even higher.
As a result, the Fed indicated last quarter that rate hikes were on the way to get rising prices under control. However, how many rate hikes – and how high each would be – remained in question until this week’s meeting.
But just because the Fed is hiking interest rates doesn’t mean that its economic outlook is doom and gloom. Quite to contrary. According to its post-meeting press release:
“Indicators of economic activity and employer have continued to strengthen. Job gains have been strong in recent months, and the unemployment rate has declined substantially. Inflation remains elevated, reflected supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.
The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. With appropriate firming in the stance of monetary policy, the Committee expects inflation to return to its 2 percent objective and the labor market to remain strong. In support of these goals, the Committee decided to raise the target range for the federal rate to ¼ percent to ½ percent and anticipates that ongoing increases in the target range will be appropriate. In addition, the Committee expects to begin reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities at a coming meeting.”Federal Reserve Press Release
A Little Bit of Background
So far, we’ve touched on what the Fed is doing and has done. But knowing what, exactly, the Fed is and should do is integral to understanding why it works.
What is the Federal Reserve?
The Federal Reserve System, or just “the Fed,” is the central bank of the United States. It was signed into existence by Woodrow Wilson in 1913 to provide the country with a safe, flexible, and stable financial and monetary system.
The Fed is considered an independent institution because its decisions aren’t subject to ratification by any governing body or official. However, it still works within the U.S. government’s economic objectives. Additionally, the Federal Reserve remains subject to congressional oversight.
You might think that running an enormous central bank is a massive financial undertaking – and you’re not wrong. But instead of pulling in tax money, the Fed’s primary source of income comes from interest charged on U.S. government securities, foreign currency investments, and loans. The Fed also charges fees for certain services within the banking sector.
Composition of the Federal Reserve
The modern Federal Reserve system is comprised of three pillars:
- The board of governors, or Federal Reserve Board
- The regional reserve banks
- And the Federal Open Market Committee (FOMC)
The Board of Governors
The Federal Reserve Board is a 7-person body based in Washington, D.C. that supervises the Fed system. Each member is appointed by the president and approved by the Senate. Appointments are staggered by two years to limit presidential and party influence, and no governor serves longer than 14 years.
The Federal Reserve Board is responsible for directing monetary policy, setting the discount rate, and determining reserve requirements. It also hires economists to perform economic analysis.
The Fed system is comprised of 12 regional banks tasked with supervising the nation’s commercial banks and banking activities within their region. They were initially created to ensure the Fed remained “decentralized” – in other words, that the central bank wouldn’t focus solely on Wall Street and Washington, D.C.
Each bank has its own president chosen by their private-sector board of directors and subject to Board of Governors approval. These “bankers’ banks,” as they’re known, provide lending, currency distribution, and electronic payment processing services to commercial banks. They also conduct and report on economic research and serve as fiscal agents for the U.S. government.
The Federal Open Market Committee
The FOMC is the policymaking body of the Federal Reserve. It’s comprised of the Fed Chair -currently Jerome Powell – as well as:
- The full Board of Governors
- The president of the Federal Reserve Bank of New York
- And four regional bank presidents on a rotating basis
The FOMC meets eight times per year to determine monetary policy and open market operations (OMOs) like buying and selling government securities. The committee is also tasked with upholding the Federal Reserve’s dual mandate.
What Does the Fed Do?
As you might guess from the name, the Fed’s dual mandate is twofold. The first objective is to foster economic conditions that achieve stable prices. The second is to ensure that economic activities support maximum sustainable employment.
You can break down the Fed’s duties into four areas:
- Supervising and regulating banking institutions to protect consumer rates and ensure smooth fiscal sailing
- Managing monetary and credit conditions to keep inflation moderate, employment high, and prices stable
- Containing or addressing systemic economic risks
- Providing critical services like operating, regulating, or supporting the national payments system, depository institutions, and the U.S. government
Examining the Fed’s Visible Activities
The Fed has fingers in many pies, but few of them are visible to consumers. For the most part, you can think of the Fed as an essential lubricant that keeps the economy and banking industry thrumming. That said, some activities are more visible than others.
As noted above, inflation isn’t inherently good or bad – in moderation, anyway. But when it runs too low or into the red (deflation), economic activity stutters to a stop, leading to recessions and higher unemployment. When it runs too hot, consumer prices soar and asset bubbles can form, potentially leading to an economic crash.
The Fed is responsible for moderating the economy and straddling that fine inflationary line between too low and too high. It does this by impacting interest rates. When rates go down, consumers can borrow and buy more, leading to growth. But when rates go up, consumers borrow less, leading to decreased economic activity. The Fed generally announces rate changes when inflation strays too far from its 2% target growth.
How Does the Fed Impact Interest Rates?
Technically, the Federal Reserve can’t change just any interest rate. Most consumer rates are determined by individual banks based on consumer creditworthiness and their profit margin needs. But the rates they set are influenced by Fed decisions, particularly the funds rate.
Essentially, when the Fed raises the federal funds rate, the price that banks charge each other for overnight loans goes up. At the same time, the interest rate that the Fed pays banks for exceeding their minimum balance reserve requirements rises, too.
When the bank increases the reserve rate, it reduces the incentive for banks to lend to consumers. After all, it makes more sense to earn a guaranteed 4% with the Fed than it does to lend to risky borrowers at 3%, or even 5%. As a result, banks tend to raise consumer interest rates.
Between hiking the funds and reserve rates, the Fed can set off a domino effect wherein everyone pays more on all kinds of loans. Because less credit circulates in the economy as interest rates rise across the board, this discourages growth. In theory, this slows demand, which can drag inflation and consumer prices back down.
How Do the Fed’s Actions Impact You?
The Fed’s work is so complicated that it’s often misconstrued (perhaps by political appendages seeking to score votes) or outright ignored. But its actions have real-world consequences – and this year’s current and planned rate hikes are no different.
Savings accounts and certificates of deposit (CDs) have paid abysmally low-interest rates for decades. But thanks to the rising federal funds rate, you may soon see – perhaps marginal – rises in your account’s APY. Generally, smaller and online banks tend to pay better rates more quickly than bigger, cash-rich institutions.
Most credit cards charge variable interest rates, which means they’re incredibly susceptible to federal funds rate changes. While higher rates may take a few statement cycles to kick in, that doesn’t mean they’re not coming. (If you’re worried about these rising rates, consider moving any balances to a 0% interest balance transfer card to mitigate the sting.)
The mortgage market has already begun pricing in rate hikes during the last few months, but that doesn’t mean rates won’t continue to rise. While current fixed-rate mortgages won’t be impacted, adjustable-rate mortgages (ARMs) and new loans will likely see slightly higher rates. The same goes for new home equity loans and home equity lines of credit.
Car loan rates tend to have more variation than bigger loans (like mortgages), as they’re heavily impacted by your creditworthiness, down payment, and the type of vehicle. You may or may not notice auto loan lenders pricing in rate hikes – but that doesn’t mean it’s not happening.
Federal student loans are set by the government, which means they’re not affected by the federal funds rate. But if you’re looking into taking out private student loans, prepare for rates to go up within the next few months.
Stocks and Bonds
When interest rates go up, the price of existing bonds falls, as older, lower-yielding bonds become less attractive. But people who own bond-holding ETF and mutual fundswill eventually benefit as the funds reinvest in higher-yielding bonds. And though short-term price drops can panic the bond market, higher yields tend to be good for long-term investors.
On the other hand, the stock market isn’t directly affected by interest rates. What can be affected is the issuing business’ debts and profits, as higher rates increase the cost of doing business and decrease growth opportunities. As such, rising interest rates tend to indirectly impact stock values when investors get their hands on future quarterly reports.
Finally, higher interest rates can encourage stock investors to shift their portfolio toward other investment vehicles. This can, and sometimes does, reduce the value of stocks overall as demand slackens. On the other hand, knowing the Fed will take decisive, but measured, action can increase confidence and calm investors, reducing volatility and improving stock prices. In other words, a small rate increase may improve stock prices (as seems to be the case at the moment), a very large increase would likely depress stocks, and for everything in between, you can only know the effect by watching.
Rising Interest Rates Aren’t a Time to Panic
Ultimately, the Fed hiking interest rates isn’t inherently good or bad – it depends on the context. At the moment, its control over the federal funds rate provides the central bank with its most effective tool to combat rising inflation. And until a better tool comes along, the central bank is doing what it does best: moderating the U.S. economy.