The Federal Funds Rate, controlled entirely by the Federal Reserve, is the interest rate that banks and other financial institutions charge each other on overnight loans. Though rate increases are not uncommon, they’re also inherently complicated – thus making them perfect candidates for misunderstanding.
Such is the case with the current news that the Federal Reserve is expected to increase rates at an upcoming meeting in June, this despite a period of relatively low inflation across the board.
Exactly why this is about to happen, what led us here and what this means for the future requires a deeper understanding of just how this process was designed to work in the first place.
How Federal Reserve Rates Work
When the Federal Reserve decides to raise or lower the prime rate, the story very rarely ends there. It typically sets off a chain reaction, affecting everything from mortgage rates to car loans to consumer loans and more. While it’s true that banks can raise or lower their own prime rate without the Federal Reserve taking any preemptive reaction, this is relatively rare.
As a rule of thumb, lower federal reserve rates typically generate positive economic activity. When this happens, both corporate and consumer borrowing becomes far easier. Higher rates, on the other hand, are actually intended to make borrowing harder – thus intentionally slowing down the economy to a much more manageable rate.
The major goal of raising or lowering the prime rate involves an effort to keep inflation under control. Too much inflation is a bad thing, as it means that the value of every dollar doesn’t stretch nearly as far as it used to. Likewise, too little inflation means that there is too much unspent money that can actually harm the economy over time. Maintaining that perfect balance is therefore one of the cornerstones to maintaining a healthy economy for as long as possible.
The Current Situation
Many experts agree that, based on six months of speeches and financial industry news reports, the Federal Reserve will increase its benchmark interest rate by one quarter of a percentage point in its upcoming meeting. Indeed, the market monetary policy tool FedWatch predicts that the probability of this rate hike is currently at 91% – essentially making it a foregone conclusion.
This news comes on the heels of two previous rate hikes – one in December of 2016 and another in March of 2016.
Even though the logic of increasing rates despite current low levels of inflation may be questionable on the surface, the long-term goal is actually straightforward. Since the financial crisis of the last decade, the Federal Reserve has been making an active effort to keep rates at levels as low as possible to stimulate economic activity.
Now, it is gradually raising rates towards levels that are historically considered to be “normal” as the United States economy continues to improve. So while the move may seem odd in the context of today, it makes perfect sense when you look at the country’s economy over the last few decades.
According to an overview provided by The Economist, the Federal Reserve actually has two primary goals: it wants to keep unemployment as low as possible, while keeping the current inflation rate as close to 2% as it possibly can. In May of 2017, the unemployment rate was at 4.3% – a rate we haven’t seen since the early 2000s.
The problem in this case is one of momentum. While it’s true that both unemployment and inflation are low, both current prices and market estimates of future inflation have slowed to a worrying pace since January. This has created another ripple effect in which wage growth has also slowed. Raising rates despite low inflation would help mitigate the future risks of current trends.
Additionally, the recent decision of the Federal Reserve has been spawned on an issue of credibility. Though there is no real current argument in favor of the upcoming rate increase, experts agree that such a move would continue to show the markets that the Fed still takes its role very seriously – and that it will continue to do what it says it will moving forward.
Again, it’s important to remember that the goal of the Federal Reserve is to create not just economic growth but the right kind of economic growth. Too much growth too fast can be a bad thing, as short-term gains often give way to long-term pitfalls sooner rather than later.
Maintaining healthy, steady growth is the primary objective – and this is precisely what representatives from the Federal Reserve say that they’re upcoming rate hike is intended to accomplish.
Regards,
Ethan Warrick
Editor
Wealth Authority
