Last week, the Fed raised interest rates. What happened and what are the implications in the short- and long-term, for individuals and businesses, domestically and internationally?
What is the Fed and what did it do? The Fed is the central bank of the U.S. One of its principal functions is to encourage economic activity and discourage inflation in the U.S. by adjusting the federal funds rate, a base interest rate in the economy. If the Fed feels economic activity should be stimulated, it lowers this interest rate to make money cheaper to encourage borrowing and spending. If the Fed feels inflation is too high – that there is too much spending which is driving prices up – it raises this interest rate to make money more costly. Since the financial crisis in 2008/09 which caused a dramatic slowdown in economic activity, the Fed has kept the fed funds rate very low, near zero. Now, as the economy is recovering and inflation is returning, the Fed has started to raise the rate again. Last week, it raised the rate by 0.25 %, to a target level of 0.75 – 1.00 %. The Fed expects to make two more rate increases in 2017 and perhaps three more in 2018. The Fed appears to be committed to a series of slow, small increases.
What does this mean for individuals? As noted, the fed funds rate is a base interest rate and, when it goes up, other borrowing and lending rates go up, too. Some banks have already started raising their rates on loans. Prime lending rates (rates banks charge on loans to their best clients) have gone up at some banks from 3.75% to 4.0%. Rates on mortgages, credit cards, car loans, etc. are on their way up, too. Interest rates will also go up on savings accounts, CDs and checking accounts, but banks often increase these rates more slowly.
What does this mean for the U.S. economy? When interest rates rise, the cost of borrowing goes up for firms and, if they slow down their borrowing and expansion, unemployment can rise and economic growth can fall. Stock prices may fall if investors think firm profits will suffer. This time, however, the stock market has reacted positively to the Fed’s action. Investors have taken the Fed’s move as a signal confirming that the economy and employment are strengthening, workers’ wages and firm profits are healthy, and prospects for economic growth are good. After all, the reasoning goes, the Fed wouldn’t have raised the cost of money if it felt there were difficult economic times ahead.
What are the risks? There are several. First, if it turns out that the Fed is raising rates prematurely, before the financial crisis is completely over, it might hold back economic growth. Second, inflation is starting to increase and it is approaching a target the Fed has set of 2 % / year. The Fed’s plan of slow, incremental increases in the fed funds rate could conceivably allow inflation to rise at a faster than desirable rate. Third, the higher interest rates could affect the value of the dollar, as better investment returns attract more international capital to the U.S. International investors have to buy dollars to invest here and that drives up the dollar’s value. A strong dollar can hurt exports and growth, and the dollar profits of U.S. firms which earn much of their income overseas.
What are central banks in other countries doing? The 2008/09 financial crisis and the global recession that followed caused many central banks to lower their base interest rates, as the Fed did, in an attempt to stimulate growth. The pace of recovery has varied by country and while some central banks have also begun to raise rates again, the Bank of England and the European Central Bank have yet to do so. They have, however, indicated that rate increases are being contemplated. The Bank of Japan is less likely to raise rates above zero in light of chronic economic problems in Japan that are not improving. In China, the Peoples Bank of China is concerned with a declining currency (the renminbi), significant flows of capital out of the country, and excessive rises in asset prices, and last week it raised rates along with the Fed.
What are the politics of the Fed’s actions? President Trump has given high priority to increasing U.S. growth and employment, and he favors a weak dollar. Higher rates could have an adverse effect on corporate borrowing, expansion, and hiring. And, if higher interest rates serve to boost the dollar’s value, exports could decrease, imports could increase, and trade deficits with trading partners could widen. Thus, the Fed’s move toward higher interest rates may conflict with key administration objectives. The Fed is an independent institution which does not take direction from the President or the Congress, but the President does have the power to appoint members of the Board of Governors of the Federal Reserve and its Chairman. There are vacancies on the Board currently and the current Chairman’s term expires next January. The President’s appointments could have an important influence on the future direction of Fed policy.