What Does It Mean? Federal Reserve Increases Interest Rates.

Stories about interest rate increases have dominated recent news. What does it mean when we hear that the Federal Reserve will raise interest rates by 0.25% to 0.50% points?

First, we should know why the Fed would raise interest rates. When the Fed decides to raise or lower interest rates, it utilizes its monetary policy tools to maintain stable inflation and maximum sustainable employment. By increasing the cost of borrowing, the Fed hopes to prevent inflation from rising too quickly while sustaining economic growth. 

Through banks, the Federal Reserve raises interest rates. These rates are known as the federal funds target rate. When banks carry out their daily operations, they will have money leaving (often in the form of loans and withdrawals) and money entering (often in deposits). When a bank's outgoing funds exceed its incoming funds, it must borrow overnight from other banks to recover the difference. When a bank has more deposits than withdrawals, it will lend its excess funds overnight to other banks that must meet reserve requirements. Reserve requirements require banks to retain a minimum amount of cash on reserve. Banks must maintain reserves because the funds deposited by customers should be readily accessible. If you wish to withdraw the $1,000 you deposited in the bank, you should be able to. Suppose the bank lends too much money and does not maintain sufficient reserves. In that case, it may be unable to supply adequate cash for withdrawals. Since banks are considered a haven for your money, inadequate cash reserves would be problematic. When you need your deposited money, you should be able to get it without difficulty.

When banks with excess cash reserves lend their excess to other banks, the interest rate they agree to is influenced heavily by the federal funds target rate, the rate at which the Fed intends for banks to borrow from one another. The federal funds rate is currently high at 4.25% to 4.50%. What does this mean for you?

Since the Federal Reserve is pushing for increases in the rates at which banks borrow from one another, the interest rates on loans issued by banks (mortgage loans, auto loans, personal loans, credit cards, etc.) will also rise. Bank loan rates will also rise due to the need for banks to recoup the costs of increasing borrowing rates. Therefore, the prime rate will increase, which is the rate banks lend to their most credit-worthy borrowers. A year ago, the federal funds target rate was 0.25%, and the prime rate was 3.25%. Currently, the target rate is between 4.25% and 4.50%, while the prime rate is considerably higher at 7.50%. Even with excellent credit, borrowing from banks is extremely expensive.

However, these higher short-term interest rates also mean high-yield savings account rates and short-term bond rates have increased. Currently, the 3-month Treasury yield rate is around 4.3%, and many banks offer about 4% on their high-yield savings accounts. 

Perhaps most significantly for you, the increases in the federal funds target rate should result in a decline in prices. Recent data from the Consumer Price Index indicate that inflation has been gradually declining, which is good news for most American households. As interest rates continue to rise, it is anticipated that prices will fall and the American economy will become more affordable. 

Effects on the Stock and Real Estate Markets

As previously established, when the federal funds target rate decreases, rates on high-yield savings accounts and short-term bonds also decrease. When the Federal Reserve reduces interest rates, people will earn less by placing their money into a high-yield savings account or a short-term bond. Lower interest rates discourage people from putting their money into these investments and encourage them to invest elsewhere, such as in the stock market or real estate market. As a result, the Fed's lowering of the federal funds target rate results in increased asset prices, encouraging investors to take greater risks by buying assets with higher potential returns. 

In the post-COVID stock and real estate booms, asset appreciation was attributable primarily to government monetary and fiscal policies, such as interest rate cuts. Many decided to pursue alternative investments because savings accounts and short-term debt offered minimal returns. In addition, lower interest rates made it incredibly affordable to borrow money from banks, encouraging individuals to invest with great confidence. This combination of elements made the perfect recipe for extremely robust asset appreciation. Consequently, it is clear that lower interest rates, set by the government's monetary policies, played a significant role in driving up asset prices in the post-COVID period.

Currently, the opposite is occurring. The Federal Reserve is increasing interest rates in an attempt to reduce inflation. The premise of this policy is that increased debt costs and returns from safer investments, such as high-yield savings accounts and short-term bond yields, will reduce investor and consumer activity. In addition, the relationship between interest rates and prices is frequently inverse. When interest rates are low, prices tend to rise due to increased demand, while the opposite is true when rates are high. Consequently, today's exceptionally high-interest rates are causing declines in specific stock market sectors and real estate markets, and these declines are likely to continue as the Fed raises its federal funds target rate. These changes, primarily due to the Federal Reserve's tight monetary policy, create an environment where businesses and consumers must adjust their spending and investment habits.

Take Away

Many aspects of the American economy link to the federal funds target rate: the interest rates we pay on loans, the yields on short-term bonds, and the prices of assets. At its core, however, the target rate represents a Federal push for banks to borrow from one another at higher or lower interest rate costs. Fluctuations in these borrowing costs can have enormous implications for you and the broader economy, so it is essential to understand what these fluctuations mean. Most importantly, it helps to remember that interest rates that we pay or receive, such as mortgage and savings account rates, tend to follow the federal funds target rate. For instance, if you hear, "The Fed is raising its interest rates by 0.50% points," understand that you will likely see interest rates increase.