How the Federal Reserve raises interest rates and why it matters

Fed Chairman Jerome
Powell.
Mark Wilson/Getty; Samantha
Lee/Business Insider

• The Federal
  Reserve on Wednesday is set to raise
  its benchmark interest rate for the third time in
  2018.
• America’s central bank adjusts the interest rates that
  banks charge to borrow from one another, a cost that is
  eventually passed on to consumers.
• The Fed raises rates in a strong economy to contain
  excesses, and cuts borrowing costs when the economy needs
  support. 

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Banks give out money all the time — for a fee.

When we borrow and then pay back with interest, it’s how banks
make money.

The cost of borrowing, known as the interest rate, can make a big
difference in which credit card you choose or whether you get one
at all.

But if your bank wants to make it more expensive to borrow, it’s
not as simple as just slapping on a new rate, as a grocer would
with milk prices. It’s something controlled higher up by the
Federal Reserve, America’s central bank.

Why does the Fed care about interest rates?

In 1977, Congress gave the Fed two main tasks: Keep the prices of
things Americans buy stable, and create labor-market conditions
that provide jobs for all the people who want them.

The Fed has developed a toolkit to achieve these dual goals of
inflation and maximum employment. But interest-rate changes make
the most headlines, perhaps because they have a swift effect on
how much we pay for credit cards and other loans.

From Washington, the Fed adjusts interest rates with the hope of
spurring all sorts of other changes in the economy. If it wants
to encourage consumers to borrow so spending can increase, which
should boost economic growth, it cuts rates and makes borrowing
cheap. After the Great Recession, it kept rates near zero to
achieve just that.

To accomplish the opposite and cool the economy, it raises rates
so an extra credit card seems less desirable.

The Fed often adjusts rates in response to inflation — the
increase in prices that happens when people have more to spend
than what’s available to buy.

For most of this economic recovery, inflation hasn’t really
picked up, though it is now well within the Fed’s target. But
that’s expected to change, since the federal government has
provided a jolt in the form of tax cuts and the
unemployment rate is at the lowest level since 2000.

For now, the Fed is not exactly raising rates to fight inflation,
though it expects prices to rise. That’s why the most closely
watched issues on Wednesday include the Fed’s forecasts for
economic growth and future
rate hikes.

So how do rates go up or down?

Banks don’t lend only to consumers; they lend to one another as
well.

That’s because at the end of every day they need to have a
certain amount of capital in their reserves. As we spend money,
that balance fluctuates, so a bank may need to borrow overnight
to meet the minimum capital requirement.

And just as they charge you for a loan, they charge one another.

The Fed tries to influence that charge — called the federal funds
rate — and it’s what the Fed is targeting when it raises or cuts
rates.

When the fed funds rate rises, banks also hike the rates they
charge consumers, so borrowing costs increase across the economy.

Floor and ceiling

After the Great Recession, the Fed bought an unprecedented amount
in government bonds, or Treasurys, to inject cash into banks’
accounts. Nearly $2 trillion in excess reserves is now parked at
the Fed. (There was less than $500 billion in 2008.)

It figured that one way to pare down these Treasurys was to lend
some to money-market mutual funds and other dealers. It does this
in transactions known as reverse repurchase operations, which
involve selling the Treasurys and agreeing to buy them back the
next day.

The Fed sets a lower “floor” rate on these so-called repos.

Then it sets a higher rate that controls how much it pays banks
to hold their cash, known as interest on excess reserves. This
acts as a ceiling, since banks won’t want to lend to one another
at a rate lower than what the Fed is paying them — at least in
theory.

In June, when the Fed most recently
raised rates, it set the repo rate at 1.75% and the interest
on excess reserves at 2%. A 25-basis-point increase on Wednesday
would set the new floor repo rate at 2% and the ceiling at 2.25%,
the highest range in more than a decade.

The effective fed funds rate, which is what banks use to
lend to one another, would then float between a target range of
1.75% and 2%.

Andy Kiersz/Business Insider

When the Fed raises rates, banks are less incentivized to lend,
since they are earning more to park their cash in reserves.

But I’m not a bank

After the Fed lifts the fed funds rate, the baton is passed to
banks.

Banks first raise the rate they charge their most creditworthy
clients — such as large corporations — known as the prime rate.
Usually, banks announce this hike within days of the Fed’s
announcement.

Things like mortgages and credit-card rates are then benchmarked
against the prime rate.

“The effect of a rate hike is going to be felt most immediately
on credit cards and home-equity lines of credit, where the
quarter-point rate hike will show up typically within 60 days,”
said Greg McBride, the chief financial analyst at Bankrate.com.

Higher rates are already being felt in the housing market.

Mortgage rates, though still low by historical standards, are
on the rise at a time when the inventory of affordable houses is
low. The average fixed 30-year mortgage rate on Wednesday was
4.64%, up from 3.85% at the beginning of the year, according to
Bankrate.com.

But higher rates bring good news for savers as banks raise their
interest payments on deposits.