When Will the Fed Raise Rates?
The benchmark rate is virtually zero
For much of the decade after the 2008 financial crisis, the question on many minds was: When will the Federal Reserve raise rates? After all, the Fed left the federal funds rate at virtually zero for years to rebuild the U.S. economy.
At a special emergency meeting on March 15, 2020, the Fed announced not just the second rate cut in less than two weeks, but several other measures aimed at making it easier to borrow money. The central bank will reinstate quantitative easing, buying $700 billion of Treasury notes and mortgage-backed securities from member banks to ease liquidity.
What Is the Fed Funds Rate?
The fed funds rate is the interest rate charged for fed funds—the loans banks make to one another to meet the Fed’s reserve requirement. While banks set this rate themselves, it rarely varies from the Fed's target rate because banks know that the Fed can use its other tools to pressure them to meet the target. These tools include the discount rate and open market operations.
How Long Did Rates Stay Low Last Time?
The Fed lowered the fed funds rate to the same 0% to 0.25% range in December 2008 to combat the Great Recession. The Fed then left it at virtually zero for seven years, only beginning to raise the target in December 2015 gradually.
The fed funds rate directly affects short-term interest rates, including the prime rate, credit card interest rates, and savings account rates. The Fed's actions also have an indirect effect on long-term rates for things like mortgages, corporate bonds, and 10-year Treasury notes. That's why the fed funds rate is so critical to the U.S. economic outlook.
Impact of Lower Rates
Rate cuts are good news for borrowers but not for savers. Interest rates on loans will be lower. Unfortunately, so will the returns on savings accounts, certificates of deposit, and bonds.
Rate cuts decrease the ammunition the Fed needs to fight future recessions. The Fed cuts rates to stimulate the economy and restore confidence. A review of past fed funds rates shows that, before the 2008 recession, the fed funds rate ranged between 5% to 5.25%. That gave the Fed a lot more room to cut. Once the rate is zero, it can't be cut anymore.
It also means the economy could be in a liquidity trap when families and businesses hoard cash instead of spending it. Lower interest rates don't give them much incentive to invest. The only way out of a liquidity trap is to raise interest rates.
Rate Cuts During the Financial Crisis
On September 18, 2007, in response to tightening credit markets brought on by the subprime mortgage crisis, the Fed began a 16-month drive to dramatically lower rates. Rates fell from a range of 5%-5.25% to a range of 0%-0.25%.
By January 2010, investors began wondering when the Fed would raise interest rates again. In response, the Fed announced its exit strategy. It focused on tightening the money supply using everything but the fed funds rate. The Fed wanted to keep that rate low since it affects variable-rate mortgages. The housing market had not yet recovered. There was a 15-month pipeline of foreclosures that kept housing prices down.
To fight the recession, the Fed kept the fed funds rate unchanged as long as possible. It increased the discount rate and cut back on other programs. That kept the prime rate and variable-rate mortgages low, supported the housing market, and kept bank credit available.
How High Can Rates Go?
Rates will go higher again once the economy improves.
When it lowered the fed funds target on March 15, 2020, the Fed's Federal Open Market Committee said,
"The Committee expects to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals,"
Historically, the fed funds rate has had a sweet spot of 2% to 5%, and the highest it's ever been was 20% in 1981. That's when the Fed raised it to combat an inflation rate of 10.3%. It also battled stagflation. That was an unusual circumstance caused by wage-price controls, stop-go monetary policy, and taking the dollar off of the gold standard.
Board of Governors of the Federal Reserve System. "Federal Reserves Issues FOMC Statement." Accessed April 6, 2020.
Board of Governors of the Federal Reserve System. "Open Market Operations." Accessed April 6, 2020.
Congressional Research Service. "Monetary Policy and the Federal Reserve: Current Policy and Conditions," Page 1. Accessed April 6, 2020.
Board of Governors of the Federal Reserve System. "FOMC Meeting Transcript, September 18, 2007," Pages 3-4. Accessed April 6, 2020.
Board of Governors of the Federal Reserve System. "FOMC Statement January 27, 2010." Accessed April 6, 2020.
Board of Governors of the Federal Reserve System. "Changes in the Intended Federal Funds Rate, 1971-1992," Page 8. Accessed April 6, 2020.
Bureau of Labor Statistics. "Historical CPI — U," Page 4. Accessed April 6, 2020.