Rising living costs have become an ongoing challenge for Americans, with food, gas, and rent prices steadily increasing. Although annual inflation has slowed slightly in August, it still stands at an alarming 8.3%, approaching levels not seen in four decades.
To combat this persistent inflation, the Federal Reserve recently decided to raise interest rates by 0.75 percentage points. This move brings the federal fund’s target range to 3% to 3.25%. Notably, this marks the third consecutive rate hike of this magnitude, with the previous one occurring in June. In fact, the increase in June was the largest observed in a single meeting since 1994.
The Relationship Between Interest Rates and the Federal Reserve (Fed)
The primary responsibility of the Federal Reserve is to manage monetary policy in the United States. This includes controlling the supply of money within the economy. While the Fed employs various tools to achieve this goal, its most prominent and impactful instrument is its ability to influence interest rates.
When we talk about the Fed raising interest rates, we specifically refer to the federal funds rate, also known as the federal funds target rate. At regular meetings, the Federal Open Market Committee (FOMC) determines a target range for the federal funds rate. This range serves as a reference for the interest rates major commercial banks charge each other for overnight loans.
Banks borrow overnight loans to meet regulatory liquidity requirements set by entities like the Fed. The effective federal funds rate represents the average rate banks negotiate for these overnight loans. This rate has a ripple effect on other market rates like the prime rate and the SOFR (Secured Overnight Financing Rate).
Given its importance, the federal funds rate acts as a crucial benchmark for interest rates within the US economy. It also exerts influence on interest rates globally, albeit indirectly. Now, let’s explore why the Fed is raising interest rates.
Unraveling the Reasons for Raising Interest Rates
Inflation has reached record highs, with prices in August being 8.3% higher than the previous year. Typically, the Fed aims for a 2% inflation rate.
Initially, the Fed was hesitant to take action despite inflation steadily climbing for over a year. Central bank officials believed the rising inflation was a temporary side effect of the post-pandemic recovery and would not become a permanent feature of daily life. However, they eventually realized their mistake and swiftly began raising rates in March.
Even after the Fed initiated these rate hikes, inflation continued to soar. Consequently, the Fed found itself repeatedly needing to intensify its response, even if it meant stalling the economy and risking a potential recession. This is the underlying reason behind the Fed’s decision to raise interest rates.
How Does the Federal Reserve Tackle Inflation?
The Fed’s ability to influence interest rates serves as its primary tool for managing inflation. Based on its assessment of the economy, the Fed may opt to raise or lower its federal funds rate, which acts as a benchmark rate. This decision affects the cost of borrowing for banks and other financial institutions, subsequently impacting individuals, businesses, and households.
Lower interest rates stimulate the economy by making it more affordable for businesses and individuals to initiate new projects, hire employees, or secure loans for significant purchases like homes or vehicles. Conversely, higher interest rates have the opposite effect, slowing economic growth by reducing consumer demand.
The Impact of Raising Interest Rates on Inflation
The Fed’s objective in raising the federal funds target rate is to increase the cost of credit across the entire economy. This results in loans becoming more expensive for both businesses and consumers, burdening them with higher interest payments.
Individuals and businesses unable or unwilling to cope with the increased payments may delay or cancel projects that require financing. Additionally, higher interest rates incentivize individuals to save money in order to earn higher interest payments, effectively reducing the amount of money circulating in the economy. Consequently, this helps lower inflation and moderates overall economic activity, cooling down the economy.
1. The Effect on Stocks
Higher market interest rates can negatively impact the stock market. As the Fed raises interest rates, borrowing costs rise for public and private companies alike. This can lead to reduced revenues and earnings over time, potentially affecting the growth rate and stock value of public companies. Moreover, the announcement of a rate hike by the FOMC can prompt traders to sell stocks and shift their investments towards more defensive options, bypassing the lengthy impact of higher interest rates on the economy.
2. The Effect on Bonds
Bonds are especially sensitive to changes in interest rates. When the Fed raises rates, the market price of existing bonds immediately drops. This occurs because new bonds with higher interest rate payments become available in the market. Investors find the comparatively lower interest rates of existing bonds less appealing, causing their prices to decrease in order to align with the higher overall rates.
3. The Effect on Savings Accounts and Bank Deposits
While higher interest rates may be detrimental to borrowers, they benefit individuals with savings accounts. This is due to the fact that the federal funds rate serves as a benchmark for annual percentage yields (APYs) on deposit accounts. Consequently, when the FOMC raises interest rates, banks increase the interest earned on deposit accounts.
4. The Effect on Consumer Credit
Consumer credit, which includes personal loans, lines of credit, and credit cards, takes time to respond to Fed rate increases. Variable-rate loans are particularly sensitive to changes in the federal funds rate because the interest rates they charge reference this benchmark. While new fixed-rate loans may feature higher interest rates, existing loans remain unaffected by changes in the fed funds rate.
Conclusion
In this article, we have explored why the Fed is raising interest rates and how it impacts the economy. We have gained a deeper understanding of the relationship between the Federal Reserve and interest rates. Thank you for reading, and remember to visit Teho.info for more insightful content. See you later!