The Federal Reserve's mission is to keep the U.S. economy moderate—not too hot or too cold, just right. When the economy explodes and “warms”, distortions such as inflation and asset bubbles can spiral out of control, threatening economic stability. That's when the Fed steps in and raises interest rates, which helps cool the economy and keep growth on track.
Interest Rates and the Federal Reserve
The number one job for the Fed is to manage monetary policy for the United States, which means controlling the money supply in the country's economy. Although the Fed has multiple tools at its disposal for this task, its ability to influence interest rates is its most obvious and effective monetary policy tool.
When people talk about the Fed raising interest rates, they're talking about the federal funds rate, also called the federal funds target rate. At its regular meetings, the Federal Open Market Committee (FOMC) sets a target range of liquidity that the government wants the government to maintain to the federal funds rate, which serves as a reference for the interest rates that major commercial banks charge each other for overnight loans they exchange with each other.
The average of the constantly fluctuating rates that arise as banks negotiate what to charge for these loans is called the effective federal funds rate. This in turn affects other market rates such as the prime rate and SOFR.
Thanks to this partially indirect regulation, the federal funds rate is the most important metric for interest rates in the US economy and affects interest rates in the global economy as a whole.
What Happens If The Federal Reserve Increases Interest Rates?
When the Fed raises the fed funds target rate, the goal is to increase the cost of loans throughout the economy. Higher interest rates make loans more expensive for both businesses and consumers, and everyone spends more on interest payments.
Those who cannot afford or do not want to receive higher payments postpone projects involving financing. It also encourages people to save to earn higher interest payments. This reduces the circulating money supply, which tends to lower inflation and moderate economic activity – a.k.a. cool the economy.
Let's look at how this applies to a 1% increase in the fed funds rate and how this can affect the lifetime cost of a home mortgage loan.
Go to a shopping family for a $300,000 mortgage with a fixed rate of 30 years. Had banks offered them a 3.5% interest rate, the total lifetime cost of the mortgage would have been approximately $485,000, of which approximately $185,000 would be interest expenses. Monthly payments will be approximately $1,340.
Let's say the Fed raises interest rates by 1% before the family takes out a loan, and the interest rate offered by banks on a $300,000 home loan rises to 4.5%. Over the 30-year life of the loan, the family will pay a total of more than $547,000, of which $247,000 will be in interest expenses. Monthly mortgage payments will be approximately $1,520.
In response to this increase, the family in this example may delay buying a home to minimize their monthly payments or purchase a home that requires a smaller mortgage.
This (very) simplified example shows how the Fed reduces the amount of money in the economy while raising rates. Besides mortgages, rising interest rates affect the stock and bond markets, credit cards, personal loans, student loans, auto loans and business loans.
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