Markets In Action

Understanding the Federal Reserve: How Does the Fed Raise Interest Rates?

Over the last several months, a significant debate has unfolded as the Federal Reserve (Fed) considers raising that benchmark rate after an unprecedented seven-year run of near-zero rates.

If you’re confused by the current debate, or don’t feel like you have a solid grasp of what it means, this primer on how the Fed manages interest rates will help.

Interest rates explained.

One of the Fed’s main tools to address the economic cycle is setting the target federal funds rate, the interest rate at which banks and other depository institutions lend to each other.

An interest rate is the cost of borrowing money. If you have a mortgage, a student or auto loan, or credit cards, you already likely have some idea of how interest rates work.

For example, you may have your eye on a new car, but may not have or want to lay out the full purchase price. So you borrow some of the cost of the car from a bank or other lender, to be repaid in monthly installments over several years, paying a little extra each month in the form of interest over the life of the loan.

As you’ve probably noticed, there are many different interest rates. The interest rate you pay on your home loan is probably different than what you pay on credit card debt or an auto loan, for example.

So how are market interest rates determined? Lenders consider many factors, including a borrower’s credit score and track record, whether there is collateral to secure repayment of the loan, and overall economic conditions including the demand for loans. They also consider benchmark rates – and the rate set by the Federal Reserve influences how much it costs the bank to fund its loans.

How does the Fed raise or lower interest rates?

The key thing to understand is the federal funds rate, which refers to the interest rate banks charge each other, usually on an overnight basis.  The target rate for those loans-the aforementioned target federal funds rate-is set by the Fed’s Federal Open Market Committee or FOMC, which we explained previously. For the last seven years, that target has been set between 0% and 0.25%.

The fed funds rate serves as a key indicator of the trend of interest rates, more directly on short-term interest rates such as Treasury bills (less than one year to maturity), but also may have some impact on longer dated Treasury notes and bonds (1 years or more to maturity).

The array of other interest rates that you’re probably familiar with as a consumer, like those for mortgages, credit cards and auto loans are impacted by changes in those Treasury rates. So while the Fed does not set interest rates for loans, the fed funds rate may influence the interest rate environment for all types of borrowing.

The current debate: to raise or to lower?

You’ve seen the news that the Fed is looking to raise interest rates, perhaps by the end of this year. It’s been nearly a decade since the last increase in the federal funds target rate, and many, but not all, economists both within and outside the Fed advocate a gradual return to a more “normal” rate environment.

The Fed doesn’t have a crystal ball that shows exactly where the economy is headed. The best it can do is to look at key indicators on labor conditions (such as the monthly jobs reports), the inflation rate, GDP growth and other measurements to divine the essential trajectory of the economy. That means the Fed is always acting in an atmosphere of uncertainty.

So why would the Fed want to see higher rates now? Why not just keep them low? There are a couple of reasons:

  • Interest rates – and in particular a benchmark rate like the Fed Funds target rate – set the tone for the cost of credit, which is critical to business and individuals making decisions on when and how to borrow and invest. With such rates at or near zero, credit is essentially free and decision making is distorted.
  • Interest rates are also an important source of income, particularly for retirees who often rely on interest as a key source of income. When safe investments like government or other types of high quality bonds yield such small rates of return, investors may look to invest in more speculative assets, which could be too risky for those in, or near, retirement.
  • Rewarding suppliers of credit with higher interest rates can increase the availability of credit as the risk of lending money is priced higher and more people or businesses may be willing to take the risk of lending. So counter to the more typical case that rising rates will slow lending, some believe that in this zero rate environment, slightly higher rates might actually increase lending.
  • Further, it’s inevitable that at some point in the future the economy will weaken, and returning to a more normal rate environment will ensure that the Fed has the tools to respond accordingly. Right now, if the economy entered recession, the Fed would not be able to cut rates further to spur more spending and borrowing since the Federal Funds rate is already near zero.

What does it mean if the Fed is “tightening” or “loosening” its monetary policy?

If you read news stories about the Fed and interest rates, you’ll likely encounter terms like “tightening” and “loosening.” This is just shorthand jargon to describe the Fed’s overall strategy for the money supply:

  • If the Fed is in a “loosening” phase, that means that the Fed wants to move rates lower.
  • If the Fed is in a “tightening” phase, then it wants to move rates higher.

In reality, the Fed’s operations can be complex and are not always easy to understand-this primer represents a necessarily simplified view of the Federal Reserve’s interest rate policy.

For a fuller understanding of the Fed’s purposes and operations, here are a few additional resources that can help:

Federal Reserve – Monetary Policy section, the Federal Reserve System Website

Three Things to Know About the Fed and Rate Hikes, Third Way

9 Questions About Interest Rates You Were Too Embarrassed to Ask,