Interest rates are going up. Last week, the Federal Reserve increased the key interest rate to between 1% and 1.25%
This benchmark interest rate, known as the federal funds rate, affects other interest rates, for example those for your credit card, mortgage, or auto loan. Essentially, it is a short-term interest rate set by the Fed for overnight lending of cash by one bank to another.
This is the fourth time since the financial crisis ended that the central bank has bumped up this important interest rate, which has been at a historic low since the recession. The increase has important implications for you, your spending, and your saving.
The Fed and interest rates: A quick lesson
The Federal Reserve (better known as The Fed) is the central bank of the U.S., and as such it sets the monetary policy of the country. It has as its mission “to help set the backdrop for promoting the conditions that achieve maximum sustainable employment, low and stable inflation, and moderate long-term interest rates.”
One way the Fed achieves its mission is by setting a key interest rate called the federal funds rate. But it has other tools at its disposal, such as buying and selling government securities, or changing something called the discount rate, which is the rate banks pay to borrow money for themselves.
In 2008, the Fed made a number of financial decisions to ease the shock of the Great Recession, when the nation was hit with a banking and housing crisis. One tactic was to lower interest rates to near zero percent.
The Fed saw this as a way to jumpstart the wheezing economy by encouraging employment, economic growth and spending. The theory: Lowering the Fed’s key interest rate would keep people spending on the things that help make the American economy grow.
Lower interest rates would encourage Americans to start spending money again, thereby stimulating growth. Recession-scarred people could obtain mortgages for new homes or construction or say, a new car at a lower rate.
Businesses would also benefit from lower interest rates. They would have an incentive to buy equipment, hire more employees, remodel, and build new factories because they’d be able to borrow cheaply. In short, they could plan for the future.
The Fed kept its benchmark interest rate near zero for years, only incrementally raising it in 2015. Fed chairwoman Janet Yellen surmised that the economy had recovered enough from the Great Recession to handle a gentle increase in interest rates.
So why raise interest rates?
Low interest rates sound pretty good! Cheap rates on mortgages and cars. What could be bad? Here’s the thing. Interest rates affect more than just the things we buy. They affect how much we save.
A low interest rate economy might be great for spenders but it makes life tough for savers. With low rates, people who hold variable interest rate debt (debt that can increase or decrease, such as an adjustable rate mortgage or interest on a credit card) have seen the value of their debt effectively decrease. But people who hold bond investments run the risk of negative returns when rates rise again.
The other problem with keeping interest rates artificially low: there’s nowhere to go from near-zero in the event we fall into another recession.
Keeping rates this low has been controversial. Some economists say that allowing Americans to believe that this era of easy lending will never end creates a false economic reality — and could lead to another bubble.
So what’s happening now?
Policymakers are expected to raise the rate “a few times a year” through 2019, putting it near the long-term sustainable rate of 3 percent.
Increasing interest rates will affect those looking to buy homes or make large investments in their business as well as interest on credit cards. It will also affect banks and their ability to lend money.
Is America ready for higher interest rates? We’ll have to wait and see.
- The Fed adopted an ultra-low interest rate policy to prop up the American economy when it was struggling during the Great Recession.
- By nudging interest rates back up, the hope is that Americans will start saving (and continue spending), that the U.S. dollar will remain strong and that employment will stay steady.
- A slow increase in interest rates isn’t felt right away. Changes in monetary policy (which includes interest rates) can take up to 18 months for the economy to feel — and react.