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Federal Reserve Lift-off Ends the 0% Era

After an upbeat assessment of the US economy noting increased household spending and business investment along with improvements in the housing and labor markets, the Federal Reserve increased the target range of the Federal Funds Rate (FFR) from [0% - .25%] to [.25% - .50%]. Overall policy will continue to accommodate additional job growth by:

  • Gradually raising the FFR, widely anticipated to be at a pace of no more than 1% a year in quarter point increments,
  • Continuing to reinvest proceeds from its sizeable holdings of US Treasury and agency mortgage-backed securities, maintaining the size of its balance sheet, which supports lower mortgage interest rates for US home-buyers.

Policymakers noted that:

  • Exports continue to be weak due to the strength of the dollar relative to other currencies,
  • Inflation is running below the 2% objective.

Increasing US interest rates without corresponding action from other central banks is likely to hurt exports by further increasing the value of the dollar. However, with 85% of US economic activity generated by household spending, business investment, and housing the impact of lower net exports should be modest. As for inflation, the Fed continues to be uniquely optimistic with double crossed fingers that it will start to rise as energy prices stabilize and a tight labor market triggers wage increases. So the actual path of interest rate policy will continue to be “informed by incoming data.”

Financial markets reacted positively, reflecting the general perception that the US economy is strong enough to absorb higher borrowing costs. US stock prices have surged this week anticipating the increase and the rally continued after the Fed announcement. 

And remember that even with this action and projected increases in 2016, interest rates will continue to be near historic lows, as the Fed stated, “for some time.”  So buyers should think long-term about the decision to buy a home and avoid overreacting to splashy headlines. 

How does the Federal Reserve raise interest rates? 

The Federal Reserve is widely expected to raise its target interest rate this week – for the first time since 2006. This marks the beginning of unwinding the emergency response to the 2008 financial crisis in which the Fed held the so called “target rate” at the historic low of between 0 – .25% in part by purchasing over $3.5 trillion in bonds to flow liquidity into the financial system to stimulate the economy. Raising rates is only the first step in a process that will take years to accomplish because moving too fast would likely jeopardize economic growth by weakening the ability of businesses and consumers to invest and spend. As a result we can expect gradual changes that bring Fed policy back to normal over time. However, mortgage, car loan, and credit card interest rates are set by lenders, not directly by the Federal Reserve. Indirectly, the Fed influences the direction of these rates with a variety of different tools. Since it has been such a long period without a rate increase, we thought a quick overview of the general process might help you better understand what the Fed is about to undertake. One thing to remember: there is a market for money and prices (interest rates) are determined by the forces of supply and demand. 

Long-term Interest Rates

To change the cost of long-term borrowing, the Fed buys and sells bonds. To lower rates, it pays cash to buy bonds, which pumps money into the financial system and the economy. For example, when the Fed purchased large amounts of bonds during and after the financial crisis, rates for mortgage and other long-term debts dropped and remained in the low single digits. When the goal is to raise long-term rates, it shifts direction and pulls money out of the economy by selling bonds. These actions impact the supply of money, which drives the price of it in the form of interest rates on long-term borrowing such as that for home mortgages and corporate or government bonds. 

Short-term Interest Rates

To help balance their short-term cash needs, the biggest banks in the country borrow from and lend to each other overnight with funds maintained at the Federal Reserve. The Fed nominally sets the interest rate on these funds (the Federal Funds Rate) and by increasing this rate it quickly boosts short-term interest rates. When we hear that the Federal Reserve is “raising rates”, this is what is meant – policymakers are changing the target Federal Funds Rate. Think of this as the base rate. It is paid by the biggest, most creditworthy financial institutions and determines interest rates throughout the broader economy. It is a target because the banks buying and selling money actually set the market rate based on supply and demand through negotiations and the effective Federal Fund Rate is an average of all the rates in these transactions. The Federal Funds Rate is the primary tool that the Federal Reserve uses to quickly change interest rates on short-term borrowing throughout the economy. As a result, the rates on short-term instruments such as savings and credit card accounts are subject to greater fluctuations. Expectations on the direction of short-term rates influence long-term rates. Actual rates paid by businesses and consumers are much higher the Federal Funds to accommodate lending transaction costs. 

These are the traditional policy tools used by the Federal Reserve to set interest rates by balancing the supply and demand for money. New tools are needed by the Fed because of the unprecedented amount of reserves in the financial system, which makes the traditional tools less effective. We will learn more about these new tools once liftoff is announced, which we are anticipating this week.