What Do Federal Reserve Interest Rate Increases Do?
The Federal Reserve raised interest rates again, but what does that mean for the average American and their finances? By knowing what United States Federal Reserve is and what power it has over our country’s economy, you can make more informed financial decisions that directly affect your future.
What is the U.S. Federal Reserve?
The United States’ central banking system, the Federal Reserve (or “the Fed”), is the most powerful economic institution in the United States, and arguably, the world. The Federal Reserve monitors risk in the financial system, sets interest rates, and regulates financial markets. During times of economic crisis, such as the 2008 Great Recession or COVID-19 Pandemic, the Fed also acts as a last-resort lender.
The Fed was established by the Federal Reserve Act, signed into law by President Woodrow Wilson in 1913 in response to the financial panic of 1907, where the stock market collapsed, banks failed, and credit disappeared.
At the time, the United States was the only major financial power without a central bank. Because the federal government lacked the resources to respond to the crisis, it had to depend on private bankers to infuse capital into the economy to sustain the banking system. Over the next several years, various solutions were proposed, eventually ending with the implementation Federal Reserve Act on December 23, 1913.
Who makes up the Federal Reserve?
The Fed is comprised of a seven-member Board of Governors, each of whom is appointed by the president to a 14-year term, subject to confirmation by the Senate. The appointment of Federal Reserve Governors is staggered by two years to limit the power of any individual president.
In addition, there is a Federal Reserve System of 12 public-private regional banks, broken into Districts identified by number and the city where the main bank is located. These Districts in order are: Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kanas City, Dallas, and San Francisco. The national headquarters is in Washington, DC.
The Board of Governors is part of a larger board, the Federal Open Market Committee (FOMC), which includes five of the twelve regional bank presidents on rotation. The FOMC sets interest rate targets and manages the country’s money supply.
What is the goal of the Federal Reserve?
The Federal Reserve works to promote a strong United States economy. This goal is interpreted to mean achieving stable prices, moderate long-term interest rates, and maximum employment.
Maximum employment is the highest level of employment, or lowest level of unemployment, that the economy can sustain without causing instability in the inflation rate. Economists typically interpret this as an unemployment rate of around 4-5%.
When prices are stable, long-term interest rates remain at moderate levels, meaning that the Fed actually operates on a “dual mandate” of maximum employment and stable prices.
The FOMC judges that an inflation rate of 2% over time, as measured by the annual change in the price index for personal consumption expenditures, to fit their goal of stable prices. When households and businesses can expect a 2% inflation rate, they can make more informed decisions regarding saving, borrowing, and investment. Predictability and stability help contribute to a well-functioning economy.
How does the Federal Reserve impact the economy?
The Fed buys and sells U.S. Treasury bonds in the open market to influence both banking reserves and interest rates. Purchasing bonds puts more money into the financial system and reduces the cost of borrowing, which means lower interest rates. The Fed can also make discount loans to banks, which increases the amount of borrowable money.
Throughout the 1990s, the Fed’s regulatory responsibilities expanded. The 1999 Gramm-Leach-Bliley Act requires financial institutions to explain their information-sharing practices to their customers and to safeguard sensitive data. These changes made the Fed responsible for enforcing provisions such as minimum capital requirements, consumer protections, antitrust laws, and anti-money laundering policies.
How has the Federal Reserve responded during times of crisis?
In 2008 during the Great Recession, the Fed slashed interest rates to boost lending and spur economic activity. Near the end of the year, rates dropped to nearly 0%, where they would stay until 2015. The Fed did a policy known as quantitative easing (QE), which was the large-scale purchase of Treasury bonds, mortgage-backed securities, debt, and other assets.
The goal of QE was to spur lending by taking bad assets from financial institutions’ balance sheets and providing them with money to be lent and providing goodwill to banks and investors that the Federal Reserve was committed to assisting them. QE purchases ended in 2014, and the Fed began slowly raising interest rates in 2015 – the first increase since 2006.
However, in 2019, trade tensions led to another cut to interest rates, which had reached 2.5%, with multiple additional cuts throughout the year. Asset-buying resumed once more in an attempt to stabilize markets.
In March 2020, the Federal Reserve returned to emergency measures to prevent an economic crisis like 2008. Rates were once again to cut to near zero, QE would resume, and new programs for direct-to-business lending were created. By mid-2021, the Fed’s balance sheet had reached a new high, doubling to more than $8 trillion.
While the response was more aggressive than before, the economic recovery has been faster than after the Great Recession of 2008. However, this fast turnaround has resulted in the highest inflation rate in decades.
As inflation persists, the Fed has begun raising interest rates. August 2020 saw the adoption of a new inflation framework, aiming to keep inflation at 2% indefinitely, tolerating periods of higher interest to average out when it is lower.
As stated within the Federal Reserve’s dual mandate, stable prices and a predictable economy create the security people need to save, borrow, and invest. If people anticipate high inflation, their working, purchasing, and other economy-impacting actions will be influenced.
What should I do when the Federal Reserve raises rates?
The concept of “rising rates” is not an inherent cause for alarm, especially because raising rates will both:
- Raise the cost to borrow money or pay off debt.
- Lead to increased dividends on savings and investments.
Depending on your situation and aspirations, a rate increase can potentially bring you closer or further from your goal.
If you plan to borrow money for a large purchase soon, such as for a home or vehicle, increased interest rates may make that purchase more expensive. You may need to reevaluate how much home you can afford or consider putting off recreational or luxury purchases that require a loan. Locking in a fixed rate rather than taking a chance on a variable loan could also save you some costs in interest if rates continue to rise.
To take advantage of high rates, consider opening a high yield savings account or certificates with strong dividend growth. In the same way that locking in a high interest rate on a loan can have you earning more, locking in a high interest rate on a savings or investment account can earn you more in dividends.
At the same time, prices may continue to increase from inflation, meaning a purchase put off today could cost more tomorrow. Try to cut back on unnecessary or voluntary spending to prioritize major purchases and seek savings wherever you can, especially on essentials such as gasoline and groceries.
What else can I do?
While the economy is larger than any one individual’s habits, understanding these systems and practicing good financial habits can set you on the right path.
By reading this article, you’ve already begun to act. It is important to not lose yourself in worry over things you cannot control. Continue to follow the changes made by the Federal Reserve and educate yourself about historical and current events regarding the economy.
Lastly, rate shopping is an important money-saving tool for both investors and borrowers hoping to make the most of every cent. While the Federal Reserve’s rate increases will impact financial institutions across the board, that does not mean that everyone offers the same exact interest rates. Rate shopping allows you to choose credit unions or other financial institutions that offer better interest rates for your needs.
To view American Heritage’s current rates, click here.