When Will the Fed Raise Rates?
The Fed Has Finished Raising Rates for Now
The Federal Reserve lowered the current fed funds rate to 1.75% in October 2019. It had raised the fed funds rate to 2.5% in December 2018. It lowered it to 2.25% in July, the first rate cut since December 2008.
The Fed changes rates through the Federal Open Market Committee meetings. Most FOMC members think conditions are not robust enough to warrant further increases.
At the July meeting, the FOMC announced it would stop reducing its $3.8 trillion in holdings of securities amassed during QE. It cited soft business spending. It's also concerned that inflation is slightly below its 2% target.
Between December 2015 and December 2018, the Fed had been gradually raising rates. The 2015 increase was the first one since June 29, 2006. The rate had been at virtually zero, between 0% and 0.25%, since December 16, 2008. The Fed lowered it to combat the Great Recession.
The fed funds rate directly affects short-term interest rates. These include the prime rate, credit card interest rates, and savings account rates. That's why the fed funds rate is a critical factor affecting the U.S. economic outlook.
The Fed indirectly affects long-term rates, such as mortgages, corporate bonds, and 10-year Treasury notes. The Fed will raise those rates when it sells its holdings of Treasury notes and bonds. The Fed acquired $4 trillion worth through its quantitative easing program.
Impact of Rate Cut
Rate cuts are good news for borrowers but not for savers. Interest rates on loans will be lower. Unfortunately, so will 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, prior to the 2008 recession, the fed funds rate was 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. That's when families and businesses hoard cash instead of spending it. Low interest rates don't give them much incentive to invest. The only way out of a liquidity trap is to raise interest rates.
How the Fed Increases Interest Rates
The Fed increases interest rates by raising the target for the fed funds rate at its regular FOMC meeting. This Federal interest rate is charged for fed funds. These are loans made by banks to each other to meet the Fed's reserve requirement. Banks set these rates themselves, not the Federal Reserve.
These rates rarely vary from the target rate. That is because the banks know that the Fed will use its other tools to pressure them to meet its target. These tools include the discount window, discount rate, and open market operations.
On September 18, 2007, the Fed began a 16-month drive to dramatically lower rates, from 5.25% to less than 1%. That was in response to tightening credit markets brought on by the subprime mortgage crisis.
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 Interest Rates Will Go
Rates will probably go higher than they are now once the economy improves. But it's still a good time to take the seven steps that will protect you from future fed rate hikes.
Historically, the fed funds rate has remained between 2% and 5%. The highest it's ever been was 20% in 1981. The Fed raised it to combat an inflation rate of 12.9%. 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.
Former Federal Reserve Chairman Ben Bernanke has said that the most important role of the Fed is to maintain consumer and investor confidence in the Fed's ability to control inflation. That means the Fed is more likely to raise rates than lower them.