Why is it important for the Fed to raise interest rates?

The Federal Reserve Bank (Fed) uses a variety of tools to manipulate unemployment, inflation, and other business cycles.

But of all the financial instruments at its disposal, the Fed’s ability to raise or lower interest rate levels may be the most influential. And, without a doubt, it is the Fed’s monetary policy that is most discussed by the media and the general public.

the Federal funds rate It has been close to zero since March 2020 when the COVID pandemic and widespread closures began to cause a financial crisis. For now, Fed officials say rate hikes are not expected until 2023 as soon. But that timeline could change depending on how the economy fares in the months ahead.

Why does it matter if the Fed raises interest rates? How could it affect inflation, interest rates on savings accounts, mortgages, and other types of financial products? This is what you need to know.

Understanding business cycles

Economies are subject to boom-bust cycles. Economies grow and grow until an event occurs, which triggers a collapse, and then the cycle repeats. These can be mild or severe, as was the case in 2007/2008 with the Great financial crisis (GFC). To understand why it is important for the Fed to raise interest rates, let’s first look at what makes economies expand and contract.

An expanding economy is one that is growing. In an expanding economy, jobs are being added (unemployment is decreasing), people are spending, and GDP is increasing. At some point, the economy inevitably peaks and growth begins to slow. Slower growth does not mean that the economy has reversed. It means that there is still growth, but the rate of change from month to month or quarter to quarter is decreasing.

When an economy peaks, consumers have peaked and GDP is essentially flat. The economy is no longer expanding. Within the economy, companies have likely raised prices as much as possible (that is, demand has stabilized). And as consumer demand begins to decline due to high prices, prices will eventually decline as well.

At the same time, companies may start laying off employees due to lack of demand. During this phase, the economy is said to be in contraction and potentially enters a recession. Eventually, the economy will bottom out (that is, low) and then start to expand again.

These cycles are normal for any economy. However, cycles can be exceeded, leading to very high inflation. On the other hand, they can fail, leading to a recession or even a depression.

The history of the Fed

The United States did not always have a Federal Reserve Bank. Before 1913, the reluctance to create a central bank was due to fear of consolidation of power. Instead of a central bank, cities had banking associations called clearing houses. Furthermore, the country was in the National Banking System from 1863 to 1913, which was a decentralized coalition of banks.

But the economy has experienced significant stock market panics throughout America’s history, sometimes followed by economic downturns. Some notable stock market panics that led to a slowdown in economic activity or even a recession were the panics of 1819, 1837, 1857, 1873, and 1893.

The last straw was the panic of 1907. During that year, The Knickerbocker Trust Company went bankrupt. The panic occurred when bank runs spread across the country. However, people were unable to withdraw their savings because the banks had no money.

During this period, the stock market fell 50% from its peak. There was no depression after the panic. But some businesses were liquidated. The stock market had recovered almost all of its losses a year later. Was JP Morgan, who brought the financial system back to stability..

However, the country knew that it could not depend on a wealthy financier every time it panicked. This led to the creation of the Federal Reserve in 1913. It was made up of 12 Federal Reserve banks and aimed to counteract the ups and downs of the economy while limiting inflation.

The role of the Fed

Since 1977, the Federal Reserve has operated under a dual mandate congressional. It is responsible for promoting maximum employment and stable prices (that is, controlling inflation).

How has the Fed done its job? Well, we had the Great Depression in the early 1930s. But to its credit, the Fed succeeded in suppressing rampant inflation in the late 1970s. Many say the Fed saved the American financial system from collapse during the Great Financial Crisis (GFC).

Starting with the GFC, we see that the Fed uses quantitative easing for virtually every economic crisis going forward. And, yes, that certainly includes the coronavirus crisis that the United States (and the world) is currently in the middle of.

Why is the Fed raising or lowering rates

When the economy overheats, the Fed raises interest rates to slow it down. An overheated economy is at full employment, experiencing rising inflation and growing GDP.

One of the key factors in an overheated economy is easy credit. If credit is too weak, people and businesses can easily spend money. And that means that companies and individuals are often tempted to go into too much debt. Inflation can also get out of control – when there’s a lot of money floating around, prices go up because everyone knows they can charge more (because of all the money floating around).

When the Fed raises interest rates, lending slows down (because it is more expensive to borrow). This seeps into the economy in the form of credit agreements. It also has the effect of reducing inflation. Lower spending means that companies will be forced to stop raising prices or, in some cases, lower prices to compete.

Rising interest rates lead to a slowing economy, but it can also result in a recession.

On the other side of the coin, the Fed will lower interest rates to stimulate economic growth. Reduced interest rates expand credit, as businesses can borrow at lower rates.

Related: Best Small Business Loans to Build Your Business

Is the economy ready for a higher interest rate?

There is much debate about whether the economy is strong and can sustain its growth or whether it is fragile and needs more stimulus. The Fed is still pouring massive amounts of stimulus into the financial system at a rate of $ 120 billion per month. That’s $ 40 billion more than during the GFC.

In addition to that, the government is stimulating the economy through direct controls on taxpayers (stimulus controls) and various fiscal programs, such as the infrastructure program.

But those who say the economy is getting hot 5.2% unemployment rate (as of August 2021). They also point out that there are many unfilled vacant positions and that GDP and stock market growth are at all-time highs. If we side with those who believe the economy is heating up, it might be time the Fed considered raising rates.

Potential impacts if the Fed raises interest rates

In today’s economy, what could higher rates mean for businesses and individuals? First, rising interest rates will start to reduce loans. As mentioned above, a decrease in borrowing can also start to slow down an economy.

Mortgage rates are currently very low, which is one of the reasons why home prices are so high. Increasing interest rates will increase mortgage rates and reduce the rate of increase in house prices.

Looking at the other side of the rate hike argument, inflation also just hit a 13-year high. When the Fed raises rates, inflation tends to slow down as loans decline. And when fewer people and businesses receive financing, it works to reduce the amount of money that is injected into the economy.

When the annual inflation rate is lower than the average salary increase, the cost of living becomes more affordable. And that makes it easier for individuals and families to meet their basic needs and save for future goals.

Speaking of savings, a higher federal funds rate will also mean higher interest rates on savings accounts and certificates of deposit (CD). Before the pandemic, it was not unusual for some high yield savings accounts offer APY greater than 2%. But those kinds of rates haven’t been heard since the Fed first lowered its rates in 2020.

Final thoughts

So what will the Fed do? The general consensus is that it will begin to downsize its bond buying program this year. That means cutting the $ 120 billion in purchases of bonds and mortgage-backed securities (MBS). While that doesn’t increase interest rates, it can cause mortgage rates to rise as MBS purchases by the FED directly impact mortgage rates.

As we’ve already noted, the Fed says it doesn’t expect to raise interest rates until 2023 or 2024. But the The International Monetary Fund has warned that it might have to do so as early as the end of 2022 to avoid skyrocketing inflation.

Ultimately, the Fed’s decision to raise rates or leave them alone will largely depend on where unemployment and the economy are at the time. If the economy is strong by the end of 2022, rate increases can be expected. But if growth has reversed by then, the Fed’s bond buying program is likely to return in full force and rates will remain near their current lows.

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