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Q&A – How the Federal Reserve Raising Interest Rates Impacts the Economy & You
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Today’s entry: Submitted via the iHeart talkback feature
Bottom Line: It’s a great question that’s often overlooked in reporting. The short answer is that the Federal Reserve’s raising of interest rates increases borrowing costs for consumers and businesses which limits the ability to borrow and spend. Less borrowing and spending equals less demand for goods, which creates less pricing pressure, or inflation overtime. I’ll come back to the specifics of our current situation, but first I think it's best to hit the reset button how this works, where we’ve been, what’s happening now, and what’s likely to happen going forward with policy based upon current economic conditions.
When you hear the Federal Reserve is raising interest rates, they’re not directly raising rates on you or businesses. The Federal Reserve rate is the rate which is charged to financial institutions you do business with. Your bank and like lenders don’t have endless supplies of money around to directly lend to you when you take out a loan. Instead, they borrow the money themselves via the Treasury Department and in turn lend it to you. At the onset of the pandemic when the lockdowns hit, the Federal Reserve Rate was cut from about 1.5% to essentially 0%. This was done to attempt to encourage as much economic activity as possible to support the US economy which had been thrust into a recession.
When the Fed Funds rate was zero, it meant it was basically free for financial institutions to access money from the federal government that they could lend to you. As a result, the rates lenders could lend money out at was lower as well. The way interest rates are determined by lenders goes like this:
- Cost of money being lent
- Credit risk of the people or entity borrowing
- Profit margin for the lender
When the Federal Reserve cut rates to zero, lenders were able to pass the cost savings directly through to those who were borrowing. Meaning a third of what we typically must pay for when borrowing money had been reduced to almost nothing. That along with the pandemic induced recession led to the record low interest rates many took advantage of over the past couple of years. Thus far this year the Federal Reserve has raised interest rates by 75 basis points (in financial lingo) or three-quarters of one percent. That means, independent of other factors, the minimum cost of borrowing is 0.75% more expensive than it was just a few months ago. As the Federal Reserve raises interest rates, they do it gradually in an effort to not shock the economy and to also see the impact of the policy on the economy monthly. This is why the monthly inflation numbers are so important. They’re the key data points which are used by the Federal Reserve to make determinations about future policy. And about that policy.
If you want to know just how bad the Federal Reserve and related economists were at reading the economy last year, all you need to know is this. The target inflation rate for the Federal Reserve is 2%. A two percent inflation rate has historically proven to be the sweet spot for the US economy. Average household incomes have averaged about 3.5% annual gains. With a 2% inflation rate in a typical year, the US economy continues to grow, and the average family gradually increases their quality of life over time as they’re able to earn more than the inflation rate. Despite the wild swings in the US economy, highlighted by the Great Recession of over a decade ago, over the twenty years preceding the pandemic the Federal Reserve had been remarkably successful in hitting their target. The peak core inflation rate was 2.9% in 2006, at the peak of the housing bubble, and the lowest inflation rate was 0.6% in 2010 as the Great Recession bottomed out. The average over the twenty-year period – right at 2%.
The success of the Fed in hitting their inflation target for 20 years during multiple recessions probably led to the cockiness of what happened this cycle. The big difference between what happened during previous recessions when the Fed cut interest rates to essentially zero and what happened this time, was what was approved by Congress and signed into law by President Biden. When the US economy was flooded with trillions of dollars brought about by the American Rescue Act on top of the cheapest possible interest rates available, it broke the system. Demand for loans and goods exploded from individuals and businesses alike. The result was near 41-year high inflation. As for where we go from here?
The number to watch relative to how high the Federal Reserve might raise interest rates is the core inflation rate, which excludes food and energy. While the actual inflation rate was 8.3% last month, the core rate was 6.2%. With a Fed target of 2% core inflation and a current fed funds rate of about .8%, the implication is that the Federal Reserve is likely to raise interest rates incrementally, often in increases of a half-percent per month by between another 3%-3.5% from here. This means all variable rate debt, like credit card debt, will progressively continue to become more expensive and it means borrowing costs for most loans will continue to become far more expensive as well. That takes us back to where I started regarding the supply and demand story based upon affordability. I appreciated the question and hope that this explanation helped.