If you casually follow the market through accessible shows like Marketplace on NPR, you’ve likely heard updates when the Fed decides to raise and lower the US interest rates. To an uninformed viewer or listener, this news might not seem like a big deal. “Why do people care that the interest rate is rising a percentage point or two?” you may find yourself asking.
Well, the interest rate does a lot more for the US economy than you might think. Controlling the interest rate is one of the ways the Federal Reserve indirectly influences the United States economy. Those small percentage points mean a lot for the future of the economy, inflation, and loan availability.
How the Fed Influences the Economy
The Federal Reserve is helicopter mom of the United States economy. You may not realize it, but the Fed’s monetary policy indirectly affects how much money is in circulation. A casual observer of the market might think the Fed only loans money to banks in time of need, but that’s just the tip of the massive iceberg that is the Fed’s influence.
The Goal of the Federal Reserve
The Fed’s goal is to keep the US economy stable and prosperous. They aim to keep employment high, avoid recessions, and keep future inflation in check. These tasks are easier said than done. The chairmen of the Fed receives constant updates on the economy to help them understand how it’s currently working and where it will go in the future.
The chief instrument the Fed uses as an indirect influence is how much money is in circulation. They use several tools to affect this element – the most prevalent of which is an interest rate hike or drop. Changing the interest rate allows them to indirectly change how much money banks lend to individuals, as well as how well someone can afford to take out a loan.
Interest Rates and the Economy
Interest is a way to incentivize the lending of money. Without interest, it wouldn’t make any sense for a bank to lend you money for that house or car. In that case, if they invested the money, they’d see a far higher return on their profits. Of course, whenever someone is borrowing something, there’s a chance they don’t give it back. Interest mitigates that risk by allowing lenders to charge a specified rate based on how reliable the borrower is.
While we as consumers might not love hefty interest rates, they’re a staple of our economy. Without them, we’d have to save all of our money before we could buy a house, which ends up hurting the economy because more money will be under our mattresses instead of in circulation.
Although the Fed has several tools at its disposal, you’ll most likely hear of interest rate changes as their first measure of influence. The interest rate is constantly changing, which can tell you which way the Fed is leaning toward the future. The Fed has a difficult balancing act of keeping prices low and keeping people employed without causing a demand that outweighs the supply (otherwise known as inflation).
Lowering the Interest Rate
When the Fed lowers the interest rate, its because they want more money in circulation. It could be because the economy is lagging, and they don’t foresee inflation on the horizon. A lower interest rate means the banks charge less interest on loans. When this is the case, people are more likely to borrow money to buy a house, car, or other large purchase.
Lower interest rates are also positive for businesses. They may take out loans for high-priced purchases or expansions that they otherwise might not. Additionally, it’s far easier to get a loan when the interest rate is low. If you can afford the monthly payments on a home, you might decide to make the purchase now instead of saving, thus injecting more money into the economy.
Raising the Interest Rate
If lowering the interest rate means that the Fed wants to create more money, an interest rate hike means the exact opposite. This is the way the Fed curbs spending in the United States. Sure, high interest rates might seem like a bad thing to consumers, but they’re essential when you consider the broad scope of the US economy.
Raising the interest rate is one of the ways the Fed prevents excessive inflation. If loan prices stay low, people have more money in their pocket to spend. This boosts the economy in the short term, but all of that money in circulation means that demand will eventually outweigh supply. If this happens, prices will rise, and people will stop spending again.
If people stop spending, businesses will have to cut costs, which means getting rid of some employees. If the Fed allows this process to go unchecked, more people will end up out of work and the economy will eventually crash.
When you see the interest rate go up, it means the Fed is trying to prevent future inflation. It may mean that you can’t afford to buy a house right now, but that’s the unfortunate cost of keeping the economy stable. If you wait for the economy to dip a little bit, you can be sure that the Fed will eventually lower the interest rate to something that you can afford.
The Federal Funds Rate
While the interest rates directly affect borrowers, the Federal Funds rate is something you might not notice at first glance. This is the rate at which banks lend money to other banks who need a reserve deposit quickly.
The Reserve Requirement
Before the government instituted the Federal Reserve in 1913, it was common for individuals to try to withdraw money from their local bank, only to learn that they didn’t have enough money to pay them. Confidence in banking was at an all-time low.
One of the primary reason the government instituted the Federal Reserve was to create trust in the banking system. In other words, they wanted to insure that if you went to the bank, you’d be able to withdraw a reasonable amount of funds at any time. This gave birth the reserve requirement.
The reserve requirement states that banks need to have a certain percentage of their account balances on hand at all times. They can’t loan-out all of their money because they need to be able to pay people who come in to withdraw.
Another way the Fed controls the economy is by setting the interest rate at which banks lend to other banks. Often, some banks will have a surplus in their reserve, while a neighboring bank needs more funds to meet their reserve. The surplus bank can lend a portion of their access to other banks, which essentially creates more money in the economy.
When the Fed wants to tamper-down the amount of money in circulation, they’ll raise the FF rate. When they want to create more money, they’ll lower it. In this way, the FF rate works much the same as the interest rate and the discount rate.
Mortgages and the Interest Rate
While car purchases are one of the driving factors behind how the Fed gauges the economy, home sales are even more important. If people aren’t buying homes, you can be sure that the Fed will eventually raise the interest rate to entice more people to buy.
Mortgage rates are affected as much as any other loan when the interest rate changes. If you have an adjustable-rate mortgage (ARM), and the interest rate lowers, congratulations you’re now paying less. One of the reasons an ARM is sketchy, though, is because if the Fed decides on a drastic interest rate hike, you could end up losing your home.
If you have a fixed-rate mortgage, the interest rate won’t mean as much to you. It’s best to get one of these when the interest rate is lower, but you could always refinance if the rate drops a few years down the line. If you decide to refinance, make sure you’re still saving money after paying some of the fees associated with refinancing a mortgage.
The Federal Reserve and Interest Rates
After reading this, you should have a better understanding of how the Fed influences that marketplace through the changes in the national interest rate. When these rates are higher, the Fed is trying to prevent inflation. When they’re lower, the Fed is boosting the economy, creating more money, jobs, and money in circulation.
Paying attention to the Fed’s movements are a good way to get a sense of how the future of the economy looks. The Fed has to balance long-term inflation with short-term growth, but have the forecasting ability in the country.
The best time to buy a home, car, or other big purchase is when interest rates are low – and that’s by design. It’s easier to get a loan, and your payments won’t be as high as they will when the Fed is trying to prevent inflation. If you know what to look for, you can adjust your spending to fit the ebbs and flows of the market.