Economics / Finance

Why The Federal Reserve Will Increase Interest Rates and What It Means for You

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After all the talk around the United States and hints from Fed Chairmen Janet Yellen throughout August, the Federal Reserve (Fed) decided not to increase the Federal Funds Rate (FFR) at their meetings September 20th and 21st. Many experts see this as a sign the Fed is waiting until after the 2016 Presidential Election and will raise interest rates at their December meeting. Others see it as a sign the economy is weaker than most believe it to be.

If you, like most Americans don’t know the effects of changing interest rates or how the Fed controls them, allow me to explain.

Ever since the 2008 financial crisis the Fed has kept the Federal Funds Rate at essentially 0 percent. The FFR is the rate that U.S. banks are able to lend to each other in order to meet reserve requirements. The purpose of the reserve requirement is to maintain a certain proportion of an asset/liability’s value to cash on hand to protect the holder of the asset. In the United States banks must meet a reserve requirement for transaction accounts (mostly checking accounts) that they hold. For large banks this requirement is 10 percent of liabilities.

The Fed has complete control over the Federal Funds Rate and has kept it low to allow banks to lend money back and forth without incurring substantial costs. This in turn allows banks to pass these savings on to consumers. Consumers who pay less on interest now have extra disposable income to spend on goods and services, which increases spending and thereby growth in the economy.

After the 2008 financial crisis, the Fed decreased the Federal Funds Rate from 5.25 percent before the crash to 0 percent after. A significant drop to reverse the recession and try to increase consumer spending. Over the past 7 years the FFR has stayed at or near 0 percent as the economy has come out of the recession and increased economic growth. For the first time since the recession, the Fed increased the FFR by 0.25 percent in December of 2015. Signaling that the economy is back to a healthy growth. More Interest rate hikes were expected to follow as the economy has moved toward full employment, but an additional hike has been pushed back so far. Due to weaker than expected inflation and other factors that are too complex for me to explain here.

The issue is that the Fed needs to increase the Federal Funds Rate even if the conditions are not completely perfect. A problem with having the FFR so low is that if the United States were to experience slow growth now, the Fed would not be able to further decrease the FFR to help prop up the economy (as can be seen in the Effective FFR graph below). We are currently not in a recession and have all but recovered from the last. The fed needs to start raising the interest rates and come December they will more than likely raise the FFR by an additional 0.25 percent. Hopefully followed by more rate hikes over the coming months and years.fedreserve

For consumers, the short run impacts of interest rate hikes will be minimal as the United States will still be at historically low levels until multiple hikes have taken place. The difference between buying a house now with a 3 percent mortgage rate or in 1 year at possibly 4 percent is not going to deter consumers from buying a home. Only in the long run when interest rates have recovered and are significantly higher will a consumer then possibly decide against buying a home. Other consumers that will feel an impact in the long run will be those with money in savings accounts or other forms of safe investments like CD’s. As the rates increase, banks will start charging consumers higher interest rates to lend money, but will keep rates on savings accounts and CD’s low. Resulting in higher payments for consumers on loans and more money for the banks.

Ultimately Americans should hope that there will be a Federal Funds Rate hike in December and in the coming months and years. The hikes would be a sign that the economy is doing well and is growing, because if there are not any rate hikes in the near future, the economy might be slowing or even receding. We all know what happened last time the economy receded and it took 4 plus years to recover.


Sources:

http://www.cnbc.com/2016/09/19/expect-a-december-not-september-hike-for-rates-fed-survey-respondents.html

http://www.cnbc.com/2016/09/12/how-exactly-will-a-fed-rate-hike-impact-your-wallet.html

http://www.cnbc.com/2016/08/26/fed-chair-janet-yellen-chance-for-raising-rates-has-strengthened.html

http://www.usatoday.com/story/money/2015/11/06/what-higher-interest-rates-mean-consumers/75300616/

http://blog.logicoffinance.com/2013/08/default-risk-modeling-little-experiment.html

http://www.investopedia.com/articles/stocks/09/how-interest-rates-affect-markets.asp

 

 

 

 

 

 

 

 

 

 

 

 

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