The Fed Moved Interest Rates – So What?

Yea yea I know what a stupid question right?  We all clearly know that when the Fed announces it is raising interest rates by .25% it is referring to the Federal Funds Rate, right?  Additionally, I’m certain it is common knowledge that this is the suggested rate that the FOMC (Federal Open Market Committee) announces that commercial banks lend their excess reserves to other banks.  Then banks take their excess reserves, as they must keep a certain percent in reserves to cover deposits and lend them to one another in what is called the overnight market.  This does not mandate that they do so or the exact rate, as it is still a negotiation between banks, however generally speaking banks follow this basic guideline. 

Everything!  Just kidding, but no seriously basically everything.  Although, when the Fed says it is moving interest rates, the reality is it isn’t directly changing your mortgage rate or anything like that.  However, since the rate banks lend to each other goes up the ripple effect is what matters.  Essentially, since the short-term high-quality baseline interest rate has been moved, then everything from there changes too.  Sooooo nearly all new debt gets more expensive, including new mortgages, car loans, college loans, credit card loans, and even existing variable interest loans go up.  If it is not fixed it goes up.  What this also means is it is more expensive for businesses to borrow funds for their projects.  The flip side of all this is bond interest rates will go up, as will your piddly savings account rates.  Thus, not all increases in interest rates are bad, but it is something to keep an eye on and a great planning opportunity.

The million (or trillion) dollar question at hand is why now?  Inflation Andrew, duh!  Ok smart guy, but why does this impact inflation?  Well, I’m so glad you asked.  For starters, the Fed has the mandate to try to keep inflation in the 2-3% range (what they refer to as stable prices).  That is their target and looked at as healthy steady inflation, as all inflation isn’t bad.  However, when inflation is drastically outside that range, either higher or lower, they look to use either accommodative or restrictive policies to try to get inflation back to their target.  Generally, the first tool in their tool bag is to adjust the Fed rates either up or down.  In recent years we’ve seen them lower these rates as inflation was nonexistent and the economy needed a boost.  Pushing interest rates down is often a tool to fight recessions, which was the case after the Great Financial Crisis and the beginning of the pandemic.  Today, however, inflation is over double their target rate in the 7% range.  This is what is causing them to act so swiftly.  The impact of restrictive monetary policy is to slow the circulation of money.  If less money is in circulation, and the money in circulation costs more, it discourages a sharp increase in prices.  Inflation is often described as too many dollars chasing too few goods, and the objective of raising rates is to slow how many dollars are out there chasing.

Now the Fed moving interest rates .25% isn’t this watershed moment by any stretch of the imagination.  However, what they have penciled in is at least a .25% increase at each of their next 6 meetings this year.  Thus, if today the going Fed fund rate is .25%-.50% this is expected to be closer to 2% by year-end, at minimum.  In layman’s terms, if you have variable interest rates, and/or looking to lock in long-term fixed interest rates, think about adjusting your timing if you are able.  It should be expected that housing market prices cool, bond yields increase, and basically anything tied to an interest rate will be decently higher at year-end.  Again, this isn’t the worst thing in the world as we have been running artificially below what is considered healthy.  That said there will certainly be an adjustment to be had by all. Much of the market reaction this year, at least prior to the invasion of Ukraine, was a repricing of these interest rate expectations.