The Federal Reserve, Interest Rates, and Why they matter

On June 17, Federal Reserve chairwoman Janet Yellen held a Press Conference announcing that the Federal reserve will (eventually) be raising interest rates. A rate hike has been expected for some time now, though no one knew exactly when. More importantly, however, what does this mean?

The purpose of the Federal Reserve is to control inflation. It does this by, essentially, controlling economic growth through interest rates. If the economy is stagnating, the Fed will lower interest rates. By doing this, borrowing (both corporate and consumer) is encouraged. Everyone wants to borrow money with a lower interest rate! However, if an economy is growing too fast, the Fed may desire to slow down this growth by raising the interest. An economy growing too fast may seem like an oxymoron, but too much growth is possible. It is in an economy's best interest to grow with sustainability, not in booms. Also, when an economy grows too fast, inflation may start spiraling out of control.

What "interest rate" does the Fed actually change, though? The rate that is always referred to is actually called the Federal Funds Rate. Investopedia explains the Federal Funds Rate as "the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight. The federal funds rate is generally only applicable to the most creditworthy institutions when they borrow and lend overnight funds to each other." ¹

To explain, suppose a bank closes the day with less money than what is required by the Federal Reserve (The Federal Reserve has mandates that say how much money a bank must close with each night). The bank is able to borrow money at the Federal Funds Rate so that the next day they have enough money to serve their customers. This is a quick, overnight loan. When the Fed raises this rate, it essentially causes a domino effect, raising all types of interest rates, everything from mortgages to car loans to bond yields. It discourages borrowing and therefore slows down the economy.

Sometimes, this rate is misunderstood, especially by politicians. It is often preached that we should "give [students] the same great deal [meaning interest rates] that the banks get..."² As explained above, a student loan interest rate and the Federal Funds Rate are not comparable. One is an overnight, nearly risk-less loan to credit-worthy institutions, while the other is years long and much more risky.

Since the 2008 Financial Crisis, the interest rate has been nearly 0% (.25% to be exact). This is extremely low, as you can see in the graph above. This has helped us recover from the recession, but it also poses a problem. Interest rates have not budged for years, and many fear that should we be hit with another financial crisis, there would essentially be nothing we could do (theoretically the Fed can push interest rates all the way to -2%, but I won’t get into that). For more information on why interest rates are so low, former Federal Reserve Chairman Ben Bernanke wrote a 4 part post on his blog about the subject (linked below). I highly recommend checking out his blog and reading some of his articles.

But today, after much speculating, Chairwoman Yellen held a conference stating that the Fed will increase rates by the end of the year.³ Many economists are saying that it may be as early as September, but Ms. Yellen told them not to hold their breath.

Janet Yellen, Chairwoman of the Federal Reserve, holds a press conference on June 17, 2015.

So what does this near future interest rate hike mean for everyone? For the average American, it means that loan interest rates will increase, but there is also the possibility of savings account accumulating higher yields as well. For the investor, it can be expected that the stock market will become more volatile, as people turn away from equity and look more towards fixed income (bonds) for investing. The reason for the shift is that the yields from bonds (the interest gained from buying a bond) have been low, so investors have turned to the stock market for higher yields. A shift in the interest rate can change that.

One group sure to gain from a raise in rates is the retirees. When interest rates are low, retirement funds have less return on investment. When interest rates rise, however, a retiree’s return on investment will increase. Many retirees have criticized the Fed for its low interest rate, since it hurt many people’s retirement income.

Generally, the fear is that the Fed will raise the rates TOO high, causing a ripple effect that will harm much of the economy. Ms. Yellen assured investors and Fed watchers that “the importance of the initial increase should not be overstated.”

For now, I don’t think anyone should be expecting some kind of rate hike in the near future. It is clear that the Fed is taking caution in raising the interest rate after having such a low rate for so long. However, it must be clear that raising the interest rate is necessary and must happen within the next year. Sitting on a near 0 interest rate for so long is like opening up an ice rink on the edge of a cliff. It is fun (well, profitable to most people who enjoy the low interest rates), but very risky, and things could go wrong very fast in the event of a recession. 

Ben Bernanke's Blog Post on Interest Rates: http://www.brookings.edu/blogs/ben-bernanke/posts/2015/03/30-why-interest-rates-so-low

Sources:

1) http://www.investopedia.com/terms/f/federalfundsrate.asp

2) http://business.time.com/2013/05/10/elizabeth-warren-students-should-get-the-same-rate-as-the-bankers/

3) http://blogs.wsj.com/economics/2015/06/17/fed-rate-decision-and-janet-yellens-press-conference-what-you-need-to-know/