The Implications of Fed Increasing Interest Rates

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( — August 26, 2017) — The Federal Reserve’s Open Market Committee (FOMC) recently raised federal interest rates, and has plans to increase the rate quarterly through the end of 2019. But what does this really mean? And is it a good sign or a bad sign for the economy overall?

What’s Actually Happening

In June, the FOMC increased interest rates for the third time in six months, putting it at 1.25 percent. The FOMC has also announced plans to increase rates by another 0.25 percent by the end of 2017, followed by three more iterative increases in 2018, with possibly further rate increases in 2019.

But what’s actually happening here? The Fed exists as the central bank for the United States government, and it’s responsible for managing the flow of money to other banks and lending institutions, as well as within the government itself. According to AEI, “Its primary duties are conducting the nation’s monetary policy, supervising and regulating banks, and providing financial services and liquidity (that is, ready cash) to depository institutions and the federal government.”

One of the Fed’s primary responsibilities, and the one most sensitive to rate changes, is its ability to provide more cash to lending institutions. The Federal Reserve interest rate is the rate at which money borrowed from the Fed is charged; a higher rate means it’s more difficult and costly for lending institutions to get money, and a lower rate means it’s easier and cheaper.

That has three main effects on the economy, which affect one another:

  • Loan rates. When banks must spend more to get cash, they tend to pass those increased costs on to consumers. This usually comes in the form of increased variable interest rates, and possibly higher rates for things like mortgages, auto loans, and business loans. High Fed rates mean higher loan rates, and vice versa.
  • Consumer spending and economic growth. Partially in response to increased loan rates, higher Fed rates are usually associated with slower consumer spending and economic growth. Conversely, low rates often accelerate economic growth and stimulate more spending.
  • Inflation. Uncontrolled economic growth may seem like a good thing, but it has one bad side effect: inflation. Increasing rates keeps growth steady and fights back against inflation. With Fed interest rates that are too low, inflation could spiral out of control.

The Fed’s job, then, is to set an interest rate that keeps economic growth and inflation in balance with one another, setting a course for the United States economy to grow steadily over time. In some ways, the Fed’s interest rate can be used as a gauge of the current state of the economy. On Q Financial explains, “because [Fed] interest rates are set in response to economic activity and projected growth, you can use them as a barometer for the present state and near future of the market.”

After the economic recession, the Fed set rates near zero to increase lending and consumer spending. It has remained near zero this entire time. Now, the Fed wants to bring rates closer to “normal,” but in an effort to avoid significant disruption, is choosing to increase rates gradually over the course of a few years.

The Good News

The good news is, the Federal Reserve believes that our economic recovery has gained suitable momentum, and no longer needs the near-zero interest rates that were used to bring the economy back from the depths of the recession. We’ve seen consistently lower unemployment, stock market growth, and more consumer spending for nearly a decade, and the Fed thinks it’s time to bring things back to “normal.” Though highly variable, the interest rate usually sits somewhere between 3 and 8 percent; even the 1.25 percent current rate is abnormally low.

The Bad News

The bad news is, the increase in rates means that personal loan rates could be going up (albeit slightly and indirectly), and consumer spending habits will likely begin to slow. In some market sectors especially sensitive to interest rates, economic growth may temporarily slow down. According to Investopedia, “When the banks make borrowing more expensive, companies might not borrow as much and will pay higher rates of interest on their loans. Less business spending can slow down the growth of a company; it might curtail expansion plans and new ventures and even induce cutbacks.”

The Bottom Line

The Fed increasing the interest rate isn’t terrible or wonderful. It doesn’t mean the economy is in perfect shape, nor does it mean we’re headed for doom. Instead, it’s a carefully calculated measure to help the economy grow in a controlled manner, so inflation doesn’t set in. Though you might be affected by the interest rate hike in small ways, it’s unlikely to disrupt your personal or professional life directly.