- High inflation rates can often lead the Fed to consider raising interest rates.
- The Fed works to support maximum employment, which is the highest level of employment that the economy can sustain without generating inflation.
- Recession fears can lead the Fed to reverse interest rate hikes to stimulate the economy.
Interest rates continue to be a popular topic in 2022 because they have a considerable impact on average consumers. These rates determine the interest we’ll pay for borrowing and the return we’ll receive for depositing money. How high will interest rates go? And how will it impact our finances?
It helps to understand how the rates are set and what conditions tend to make interest rates rise and fall. In this article, we’ll discuss why the Federal Reserve decides to raise interest rates and how they do it. We’ll also learn about the factors that influence the Fed’s decisions.
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How are interest rates determined?
In the United States, the Federal Reserve sets monetary policy, managing the nation’s money and money supply. It decides how many dollars are in circulation in the nation’s economy, which influences how hard or easy it is to get loans. The Fed’s goal is to pursue full employment, stable prices, and moderate long-term interest rates. The hoped-for result is steady economic growth for the nation.
The Fed, which is the country’s central banking system, sets the Federal Funds Rate. This is also known as the Fed Funds Rate or FFR. It’s a target rate set by the Federal Open Market Committee (FOMC), a branch of the Federal Reserve. The FOMC meets at least 8 times a year to discuss market conditions, the interest rate forecast, and whether interest rates should be changed.
The target range is the suggested rate for banks to use to borrow or lend excess funds to each other. It directly impacts the economy because the higher the short-term rates banks charge each other, the higher the rates they charge customers. Investors watch these rates closely, so any changes affect the stock market and the demand for bonds.
The Fed Funds Rate also moves the prime rate—the interest rate a bank charges its most trusted customers. For some loans, banks set interest rates as the prime rate plus a certain number of percentage points. Actions by the Fed ripple out into mortgage rates, auto loans, and almost all forms of borrowing. Credit card interest rates are typically tied to the prime rate and rise with federal interest rate hikes, as do adjustable rate mortgages. However, a consumer with a fixed-rate personal loan won’t have to pay more on it after a Fed rate hike.
Recent moves and previous rate hikes
In November 2022, the Federal Reserve raised interest rates for the sixth consecutive meeting. The move set the Fed Funds Rate at 3.75 percent to 4 percent, its highest level in 15 years. In announcing the latest increase, Federal Reserve Chair Jerome Powell said more rate hikes were coming. Why? The Fed wants to keep inflation from burning out of control, so it’s throwing cold water on the economy.
The consumer price index, a key gauge of inflation, was at 0.2 percent in May 2020. By June 2022, it had jumped to 9 percent, the highest rate since 1981. The Fed wants to slow down the economy and curb inflation as soon as possible. The higher inflation goes and the longer it stays high, the more pain the Fed might have to inflict on the economy to bring it down.
The battle with inflation in the 1970s and 1980s offers an example. Decades of low inflation ended in the 1970s, with inflation hitting 11.1 percent in 1974. It moderated a bit but peaked at 13.5 percent in 1980. The Fed raised interest rates to as high as 20 percent to stop inflation. It worked, but nearly 4 million people lost their jobs in recessions prompted by the rate hikes.
Let’s examine why the Fed changes interest rates.
Inflation reflects the rise in prices over time and generally indicates a strong demand for goods and services. It can be set off by increased public spending (which means more dollars competing for the same goods, services, and labor), shortages of materials and labor, and other factors. It cuts into consumer purchasing power because it makes things more expensive. That 9 percent inflation rate in June 2022 meant that a basket of goods that cost $100 in June 2021 cost $109 a year later. (The Fed’s target inflation rate is 2 percent.)
As interest rates rise, individuals and businesses find that it’s harder and more expensive to obtain credit. They may be spending more on mortgage interest and other interest payments. That puts downward pressure on business activity, including the housing market. Investors watch closely for rate hikes, and the stock market can decline on the expectation of reduced business activity. On the other hand, bond prices tend to fall.
The Federal Reserve started a campaign in 2022 to fight inflation by taking aggressive measures, resulting in the highest number of rate hikes since 2005. The Fed hopes that, with higher interest rates, consumers and businesses will spend less money. As spending declines, the lower demand will bring down prices.
The economy enters into a recession when we see a contraction in gross domestic product for two consecutive quarters. That’s when the Fed can use monetary policy to stimulate the economy. Ideally, they do this before a recession occurs.
The Fed can set lower interest rates and take other steps such as purchasing government securities and reducing reserve requirements. Lower interest rates make it easier and less expensive for businesses and consumers to get credit.
When the Fed raises or lowers interest rates, it can have a significant impact on the labor market. The Fed works to support maximum employment, the highest level of employment that the economy can sustain without generating inflation. Ideally, it’s an economy in which almost everyone who wants to work has a job.
World economic conditions
All over the world, the U.S. dollar is considered a benchmark of economic growth and health. Interest rate changes in the U.S. create a ripple effect throughout the global market. Rising interest rates mean a stronger dollar. Disruptions in the oil market in the 1970s contributed to that era’s inflation trouble. Something similar could influence the Fed’s actions now.
Higher or lower: Where will rates go?
No one can say how high rates will go or how long they will stay elevated. Historically, as inflation cools, the Fed leans toward an end to rate increases and, eventually, shifts toward decreasing interest rates. The Fed will closely monitor unemployment rates, too. An increase there could indicate a weakening economy.
The balancing act for the Fed is in deciding to increase rates only as high and for as long as necessary to bring inflation down to its 2 percent target. The goal is a “soft landing” for the economy. Fed Chairman Powell stated in November 2022 that more rate increases were coming, and he had his doubts about a soft landing. Financial experts will analyze the Fed’s statements and economic conditions to try to anticipate how big those rate increases will be and how long they will continue.