Fed Rate Hikes
Everyone has felt the impact of high inflation in 2022. Whether it was on a major purchase, filling up at the gas station, or picking up some necessities at the grocery store, the rise in prices has certainly been noticeable. This jump in inflation to levels not seen since the early 1980s has also resulted in a lot more news coverage and interest in the Federal Reserve and their interest rate decisions. If you have seen any of this coverage, you might have asked yourself a few questions, such as: What interest rate are they changing? What impact does it have on me? What is the goal of raising these rates? We summarized our thoughts on these questions below.
What rate is the Federal Reserve changing? The Federal Reserve, or more specifically the Federal Open Market Committee (FOMC), has control of the Federal Funds Rate. Banks often enter into overnight loans with each other for their reserves held with the Federal Reserve. The Federal Funds Rate is the interest rate charged on these loans (Policy Tools, 2020).
What impact does it have on me? While the Federal Funds Rate sounds like it should only impact banks, it is the building block for many other interest rates. If you link together the current Federal Funds Rate and the expected rate for future time periods, you essentially have the framework for how the market prices short-term Treasury bonds. The relationship is muddied as you get into longer term bonds, but the Fed’s decisions impact the yield on Treasury bonds.
The level of these rates then flows through to impact the yield on savings accounts, the interest rate on new loans to individuals (car, mortgage, etc.), and the cost of financing to businesses. In short, changes in the Federal Funds Rate affect almost all interest rates, from yields on bond investments and cash to those offered on loans.
What is the goal of raising these rates? The goal of raising rates is to fight inflation and accomplishes this by slowing down the economy. The general idea is that if the cost to finance purchases and new projects is more expensive, people and businesses will spend less, causing demand to fall, which should also make inflation decline. A follow-up question you may have is, “Why would slowing down the economy be a good thing?” It may help to think of the example of a race car driver trying to win a race on a course with a lot of twist and turns. The goal is to get around the track as fast as possible, but there will be times when the driver needs to use the brakes to keep control of the car.
The Fed is essentially doing the same thing. Inflation surged and unemployment hit lows not seen in decades coming out of the market’s COVID recovery. To avoid a crash, the Fed is trying to regain control and keep the U.S. economy on track. The challenge in the case of both the race car driver and the Fed is knowing when and how hard to hit the brakes. The Fed is looking for the so called “soft landing” where it can have inflation come down to target without slowing the economy too much.