Since the end of 2016, the U.S. Federal Reserve has raised interest rates three times, with another one expected in December 2017. In addition, many market participants expect the Fed to raise rates as many as four more times in 2018.
In actuality, the Fed only has direct control over one interest rate, namely the federal funds rate. This is the rate at which a depository institution, mainly a commercial bank, lends funds maintained at the Fed to another bank overnight. That rate is set by the Federal Open Market Committee (FOMC), which is the Fed's primary monetary policymaking body.
Still, the fed funds rate, as it is more commonly called, is one of the most influential interest rates in the U.S. economy. It directly or indirectly affects monetary and financial conditions, which in turn have a bearing on the broad economy including growth, employment and inflation.
It is also the benchmark that determines the level of almost all other interest rates. This includes the rates banks pay depositors to hold their money in addition to the interest rates they charge on loans, both short-term and long-term, from business and industrial loans to consumer loans such as credit cards, auto loans and mortgages. The fed funds rate also has a profound effect on the value of the U.S. dollar.
As one would expect, the higher the rate, the more expensive it is to borrow money. That's why the Fed's raising or lowering of the fed funds rate is so critical.
The Fed's Dual Mandate
Under its congressional charter, the Fed has two mandates: promoting maximum employment and keeping prices stable.
By lowering the fed funds rate, the Fed hopes to promote economic growth by doing the following:
- Incentivising companies to borrow more money to expand, whether to hire more workers or build more factories or office buildings.
- Lower rates also incentivise consumers to take on debt to buy things, such as homes, automobiles, appliances and other goods, which also affect overall economic growth.
Conversely, if the Fed believes that the economy is running at too fast a pace, possibly triggering a rise in inflation, it will raise the fed funds rate to make it more expensive for businesses and consumers to borrow, therefore reducing demand and cooling off the economy.
The Fed generally makes changes to the fed funds rate in 25 basis point increments. As of November 2017, the Fed's target for the fed funds rate is 1.0% to 1.25%.
Here's how various types of loans and economic activity can be expected to be impacted by an increase in the fed funds rate.
The Prime Rate
Following an increase in the fed funds rate, banks generally immediately raise their prime rate, which is the base rate for lending money to their most creditworthy customers. It is also the rate on which many other forms of business and consumer credit are based.
Credit Card Rates
Interest rates on credit cards, which are usually variable, are very closely tied to the prime rate. As a result, consumers who carry a balance on their credit cards can expect to see an immediate increase in their borrowing costs. That may influence some people and cause them to reduce their spending.
Auto Loan Rates
Some auto loan rates are tied to the prime rate. However, loan rates on new cars tend to be more generally tied to incentive programs from the major auto manufacturers, which have seen fit to subsidise the interest rates they charge in order to incent consumers to buy cars. Indeed, interest rates on auto loans have generally stayed below market interest rates since the global financial crisis. Although, a rise in rates will keep some people from buying cars or cause them to purchase less expensive ones.
Long-term mortgage rates are not directly affected by a change in the fed funds rate, but they can be indirectly. That's because a change in the fed funds rate generally affects the overall trend in inflation and interest rates, including long-term. As a result, if interest rates rise, even by just a fraction of a percentage point, prospective homebuyers may find themselves priced out of the market. This could lead to a decline in home sales as well as other products that new homebuyers typically purchase, such as furniture, appliances, carpeting and the like. Higher rates also discourage existing homeowners from refinancing into a lower rate mortgage.
Conversely, higher rates could have a positive effect on the rental market, as more people choose to rent when owning becomes less affordable. However, that price differential is usually only temporary, as landlords will also see their borrowing costs rise, which they will eventually pass onto their tenants.
Rates on variable-rate mortgages and home equity lines of credit are directly tied to changes in the prime rate. A rise in HELOC (home equity line of credit) rates therefore could lead to homeowners deciding not to make home improvements, which could in turn lead to lower sales and business activity at hardware stores and contractors.
Interest rates on savings deposits, money market funds and certificates of deposit can be expected to increase following a rise in the fed funds rate. This can create incentives for people and businesses to hold their money in the bank while discouraging them from spending it. That's how raising the fed funds rate can lower inflation and economic growth.
U.S. National Debt
The rate governments pay on their debt is also impacted by a change in the fed funds rate, especially for the federal government, the biggest borrower of all. Higher borrowing costs for the government can lead to higher tax rates in order to pay for them. Higher debt service costs also can take money away from other government programs.
Other things being equal, higher interest rates could lead to a reduction in business growth, which in turn could adversely affect profitability and therefore stock prices. However, higher interest rates generally have a positive effect on bank profitability. Generally, the higher the rate, the more profitable banks tend to be. This is because they usually raise their borrowing rates much faster than their deposit rates, which increases the spread between the two, their major source of income.
The US Dollar
An increase in the fed funds rate affects the value of the dollar in two ways:
- First, raising rates normally reduces inflationary pressure, which helps to make the dollar more valuable.
- At the same time, higher interest rates attract foreign investors to buy dollar-denominated bonds, which also raises the value of the dollar as these investors have to exchange their money into dollars in order to buy the bonds.
Many people believe that the U.S. Federal Reserve sets interest rates—plural. In reality, the Fed has control over only one rate: the federal funds rate, which is the rate depository institutions charge other banks for overnight loans. But that rate affects most all other borrowing and deposit rates, both directly and indirectly, throughout the economy, from credit cards to mortgages to the federal debt. By raising the fed funds rate, the Fed hopes to control the pace of economic activity to ensure that inflation does not run out of control.
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Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…