What Is This About Interest Rates & Who Is The “Fed” Anyway?

The news is abuzz with talk of a likely federal funds rate increase this week. Many analysts and economists predict that the Fed will take action to raise the federal funds rate from near zero. This has left many people wondering: “what is this federal funds rate increase all about and how will it affect me?” In this blog post, we endeavor to answer some basic questions about the Fed, the federal funds rate, and what a rate increase might do.

Who is the Fed?

The Fed, or Federal Reserve System, is the central banking system of the United States. Established by Congress in 1913, the Fed has three primary objectives: maintain maximum employment, stable prices, and moderate long-term interest rates through use of monetary policy tools.

What are these monetary policy tools?

The Fed uses three monetary policy tools to influence the economy. Two of these tools, reserve requirements and the discount rate, are set by the Board of Governors of the Federal Reserve System (FRB). The reserve requirement is amount of money a bank must hold at all times. Banks generally hold these reserve funds, called federal funds, at a Federal Reserve Bank. If a bank cannot meet its reserve requirement, it can borrow reserve funds overnight from the Federal Reserve Bank. The discount rate is the interest the Federal Reserve charges for these overnight loans of federal funds. The Federal Open Market Committee (FOMC) controls the third tool, open market operations, which involves the purchase and sale of United States Treasury Securities in/on the open market. These tools work in conjunction to influence the demand for and supply of money that depository institutions hold at the Federal Reserve Banks and, in turn, affect the federal funds rate.

What is the federal funds rate?

Banks are not limited to borrowing from the Fed to meet reserve requirements. Banks may also borrow from each other. The federal funds rate is the interest rate banks charge each other for overnight loans of federal funds held in reserve at Federal Reserve Banks to meet reserve requirements. Because banks have the option of borrowing from one another or from the Fed, the discount rate set by the Fed affects the federal funds rate.

How does the federal funds rate affect the economy?

Changes in the federal funds rate affects the cost of borrowing money for banks. This has a ripple effect, changing interest rates, exchange rates, and even the amount of money and credit available. The Fed lowers the federal funds rate in periods of economic hardship to reduce interest rates and increase the amount of money available in the economy to stimulate economic growth. As the economy improves, the Fed increases the federal funds rate back to “normal.” In periods of unsafe run away economic growth, the Fed may increase the federal funds rate above “normal” to rein in the economy to prevent a future collapse.

How does the Fed determine when to change the federal funds rate?

Again, the Fed has three primary objectives: maintain maximum employment, stable prices, and moderate long-term interest rates. Thus, though the fed looks at numerous economic indicators to make its determination, it gives particular weight to unemployment and inflation. The Fed generally considers 5% unemployment and 2% inflation to be indicative of a healthy economy.

So why may the Fed raise rates now?

In an effort to spur economic growth in the wake of the Great Recession, the Fed reduced target federal funds rates from a 4%+ range in 2008 to a 0-0.25% range in 2009, and that’s where the federal funds rate has remained. Since the Great Recession, the S&P 500 has regained all of its losses and then some and unemployment has fallen back to roughly 5%. This has brought calls for the Fed to increase the federal funds rate to “bring things back to normal.” Very generally, the worry is that if the Fed does not increase rates, the Fed would be left helpless if there were another recession because the federal funds rate is already just about as low as it possible without seeing negative interest rates as we have seen in some European countries. However, opponents cite our current inflation of 1%, far short of the 2% goal, as an indication of economic weakness and fear a rate increase might shock the economy. Moreover, an increase in interest rates would put our monetary policy at odds with that of Europe and many other developed economies, making our businesses less competitive.

What are our thoughts?

We have been at the current near zero rates since 2009. They feel normal, but they are not. The current low interest rates are like medicine. We cannot stay on the meds forever. They were necessary to recover from the Great Recession, but now we must be weaned off. If we do not, the side effects will cause problems such as companies taking on too much debt because it is cheap or investors moving taking on too much risk moving into junk bonds in an effort to see some returns. As we wean ourselves off the meds, there will be withdrawal symptoms. Bonds will take a hit as their interest rates become less competitive with rising rates and stocks may take a bit of a tumble. However, if done right, a slow and steady progression back to normal rates should minimize the withdrawal symptoms and set us up for better, stronger growth in the future.