On March 15, 2017, the Federal Reserve Bank made the decision to increase the target range for the Federal Funds Interest Rate to between 0.75%-1.00%. To start, what is the Federal Funds Interest Rate? The “Fed Funds Rate” is the rate that banks earn on money that they loan to other banks. The Fed Funds Rate is not the same thing as Prime Rate, which is the lowest rate banks charge to consumers to borrow money. The Fed Funds Rate is important because it is a major factor when each bank determines what their Prime Rate will be.
Why would banks need to borrow from other banks? Banks are required to hold a certain amount of reserves (or cash) on their balance sheet based on the size of their lending portfolio. Banks that have more deposits than they need may lend these funds to other banks through the Federal Reserve. Banks that are short on deposits may need to borrow funds to meet their reserve requirements. This gives lending banks the chance to earn something on their excess cash, rather than just showing it on their balance sheet earning nothing. Ideally, most banks would prefer not to hold excess cash. They would prefer to lend the money to customers at higher consumer rates (4-6% or more) instead of the 0.75%-1% they would earn by lending to other banks through the Fed. However, that ideal balance between deposits and loans is not always possible, and lending the excess through the Federal Reserve is a way to generate some return on the bank’s assets.
What are some of the implications of rising interest rates? First, the cost to borrow money will go up. Rising rates take money out of the hands of consumers, giving people less money to spend. Second, deposit rates may slowly inch higher. However, do not expect to see checking/savings/CD rates at banks to automatically increase as well. We have been in an extremely low interest rate environment for several years now, so you may find that banks’ lending rates will increase, while their deposit rates will remain stagnant or see very little change in the near future.
The Fed often decides to raise rates due to the threat of rising inflation (the increase in the price of goods and services). The typical relationship between inflation and interest rates is as follows: as interest rates are lowered, individuals and businesses have more money to spend. In the past, this has led to a growing economy and higher inflation. In contrast, as interest rates go up, individuals have less money to freely spend, the economy slows down, and inflation drops. By adjusting rates up or down, the Fed tries to strike a balance for a stable economy, with maximum employment and consistent prices.
Why did the Fed decide to raise the Fed Funds Rate at this time? On an economic level, it means that the Federal Reserve believes the economy is strong enough to support an increase in rates. The Fed watches economic data to support this decision, such as positive job growth, low unemployment, increasing wage growth, and the potential for increasing inflation. All of these point to a steady US economy. The Fed will continue to monitor these data points very closely to ensure that this positive economic momentum continues. If growth slows or interest rates go up too fast, it could put a strain on the economy and lead to another recession. The current expectation for scheduled rate hikes is two more increases for 2017 and three projected increases for 2018. These are all subject to change based on continuous evaluation of the many pieces of the information that the Federal Reserve Bank uses to determine if a rise in rates is appropriate. In the end, this is an ever changing and always fluid evaluation. At this point the Fed is moving very, very carefully.