What Happens When The Fed Raises Interest Rates?

There has been a lot of talk recently about the Federal Reserve raising interest rates. First, remember that the Federal Reserve only actually sets interest rates for banks. Specifically, the Fed sets two interest rates. The first interest rate, called the Discount Rate, is the interest rate the Fed charges banks for an overnight loan. The second rate is called the target rate, and this is the interest rate the Fed tries to achieve via the open market operations.

Since the monetary crisis that started off the Great Recession, the Federal Reserve’s target interest rate has essentially been zero. The purpose of such a rate is to make it more worthwhile for banks to lend money. The idea is that more money in the economy stimulates additional growth. The economy is still growing very slowly, but it is still growing, which brings us to raising interest rates.

Interest Rates Growth and Inflation

fed raising interest ratesIn physics, basic equations come with the caveat that they are true, on a friction-less plane, in a vacuum. In other words, if there is no gravity or wind resistance. Such calculations are useful for understanding concepts, but would be devastatingly inaccurate for use in the real world. Likewise, many economic concepts can be reduced to simplicity by ignoring a host of real world factors.

Once we ignore all of the other influences on the economy, we get the concept that if money is cheap (interest rates are low), then consumers and businesses will spend it on new equipment, new goods, new services, etc. This spending allows other consumers and businesses to have money to spend, and so on and so forth. This is considered “stimulative”, which means that it helps the economy grow.

If the economy grows too fast, then inflation occurs (again, this is only in the simplest of models, there are a lot of real world factors that matter here as well). Inflation occurs because money is “cheap.” That is, too many people have too much money. If we use the equally simple model of supply and demand, it looks something like this:

Widgets cost $100. With low interest rates and lots of spending, then a lot of people have extra money to spend on widgets. Since more people are buying widgets, there is more demand, and the company will raise the price of widgets accordingly. When this happens across the economy prices rise, and inflation occurs.

To prevent this, the Federal Reserve can do the opposite of lower interest rates. When the Fed raises interest rates, then it becomes more advantageous to save some of that money rather than spend it. Also, it becomes more expensive to borrow money, so consumers and businesses are likely to cut back spending rather than expanding their credit.

Back to our widgets, if the demand falls (or better yet, never increases enough to generate higher prices in the first place) then prices stop rising and inflation is “tamed.”

Target Inflation

In reality, inflation cannot be stopped. More people means more goods and services and more labor. There simply has to be more money to accommodate this. Thus, the Fed’s goal is not necessarily to eliminate inflation, but rather to keep it small. A growing economy is an inflationary economy, all other things being equal.

The trick for the Fed is to allow growth and a little inflation without allowing too much.

For some, the time to start raising interest rates is now.

What Happens When The Fed Raises Interest Rates?

When the Fed raises interest rates, the effects can take some time to come online. This is the difficulty of the Federal Reserve’s job. They must predict both what their actions will cause, and how long those effects will take to impact the economy, while also predicting what the economy itself will do in the mean time.

For consumers, the results tend to show up first in their credit card interest rates. Most credit cards have a variable interest rate equal to some benchmark interest rate plus some amount. So, when the Fed raises rates, the interest rate charged by your credit card goes up.

Likewise, banks will raise interest rates for new loans. That means instead of being able to afford a $35,000 car, maybe you can only afford a $32,000 car loan. Home loans are eventually effected to, indirectly.

Overall, the economy should slow its growth and prevent inflation.

The million dollar question is when it the right time. Too soon, and the economy stagnates or falls back into recession. Too late, and inflation takes hold before rates can rise.

 

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