The Fed’s Rate Increase Explained

No one knows just what the Fed does, but here's the skinny on what it means to you

The Federal Reserve’s .25 percent rate increase Wednesday may seem like a minor event to those who are not economics gurus or Wall Street observers.

But the move, the first rate increase in nearly a decade, signals the start of a gradual increase in borrowing costs that will have ripple effects across every aspect of the U.S. economy.

Here are some facts about the Federal Reserve and what Wednesday’s action could mean to you.

What is the Federal Reserve, and what is its purpose?

The Fed is the U.S.’s central bank. It was created in 1913 in response to a series of panics that resulted in bank runs and fears of instability throughout the financial system. Its responsibility is to foster a healthy economy by managing the country’s money supply.

More specifically, its objectives are to ensure price stability — by keeping inflation below 2 percent — and to keep unemployment below 5 percent. These twin goals are often referred to as the Fed’s “dual mandate.”

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How does the Fed do this?

The Fed’s primary tool for fulfilling this dual mandate is its control of the federal funds rate, which is the interest rate that commercial banks charge one another for short-term loans. By raising this rate, the Fed can increase the cost of borrowing and slow down the economy if signs of inflation are mounting. The reverse is also true. If the economy is in a slump, lowering interest rates will provide cheaper access to credit and have a stimulating effect on spending by businesses and consumers.

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How does manipulating interest rates affect the economy?

Manipulating the benchmark interest rate is a powerful yet notoriously blunt instrument, and the use of this technique to manage the economy is hardly an exact science. In short, timing is everything. Raising rates too early can have a stifling effect on economic growth and job creation, while keeping rates too low for too long increases the risk of high inflation and asset bubbles, such as the housing bubble during the mid-2000s. Both outcomes can have highly detrimental effects on workers and households.

How will higher interest rates affect me?

Higher interest rates will reverberate across every sector of the U.S. economy in the form of higher borrowing costs for businesses and consumers. But because the impacts of rate changes are not fully borne by the economy for 6-12 months, and because the Fed has signaled it intends to bring rates back up to pre-crisis levels gradually, there won’t be any monumental changes overnight.

Though interest rates on consumer loans are not directly tied to the federal funds rate, banks that face higher rates on their short-term borrowing will have to pass these costs on to consumers on longer-term credit products like credit cards, mortgages, auto loans and home equity loans.

But there is nothing inherently bad about higher interest rates. Credit may become more expensive, but households will have more incentive to invest and save for the future. In the zero interest rate era, which we are just now leaving, savings accounts have rarely yielded more than the rate of inflation — in which case one would be better off just spending the money immediately. Higher rates of return on products like money market funds, mutual funds and corporate bonds will prompt higher levels of saving.

Why is the Fed raising rates now?

While the Fed’s Board of Governors voted unanimously for the rate hike, there is no consensus among economists that now is the right time. The Fed’s justification is that job creation and economic growth have been strong enough over the past year to conclude that the worst days of the downturn are over. Higher rates can slow economic growth by limiting borrowing. But wage growth has remained stubbornly stagnant, and one of the main drivers of the declining unemployment rate is that people are giving up looking for work entirely. Hence, there is a very real concern that, if this rate hike is premature, American workers and households who thought they were out of the woods may find themselves back in troublesome economic times.

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