The Basics of Federal Interest Rates

Courtesy of The Balance

Written by Chelsea Tang

On March 20th, the Federal Reserve stated that they are unlikely to raise interest rates this year. For now, they are signaling the market is no longer overheating, and that chances of an economic slowdown are slim; at least, for now.

The Federal Reserve’s decision faces opposition from potential Federal Reserve Board nominee Stephen Moore. He advocates for cutting rates because he is worried about deflation caused by a combination of a pro-growth policy, which increases the global demand for dollars, and the Fed increasing interest rates, which decreases the amount of dollars in circulation (not sure how these would create deflation). However, cutting rates will leave little leeway for the Fed to react to a stumble in the economy. It can at most cut interest rates by a bit more than 2%. Until circumstances change, the Fed has suggested that it will leave the rates at 2.25-2.5%.

Eight times a year, the Federal Open Market Committee (FOMC), headed by Jerome Powell, meets to determine the Federal Funds Target Rate. This is the interest rate at which banks and credit unions lend money to each other overnight. The FOMC either increases, decreases, or leaves the rate unchanged depending on the meeting’s agenda and the economic conditions of the United States.

The Fed monitors a few factors– inflation, unemployment, and GDP– to determine whether a rate hike is necessary. When the FOMC wants to decrease interest rates, it will increase the supply of money by buying government securities. On the other hand, the FOMC can sell government securities, taking money they earn on those proceeds out of circulation, thereby reducing the money supply to increase interest rates. The Federal Funds Rate is equivalent to the cost of money, so the Federal Reserve normally responds to recessions by lowering it to stimulate the economy.

The Fed plays an important role in the economy, and uses interest rates to signal its economic outlook. A hike in interest rates signals that the Fed wants to slow down increases in price; consequently, consumers spend less. A decrease in interest rates signals the Fed wants to jumpstart the economy so consumers spend and borrow more. While the Fed’s future decisions remain unknown, it will ultimately do what it believes is best for the economy.

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