When Will the Fed Raise Rates?
The Fed Will Continue Raising Rates Through 2018
The Federal Reserve will raise the fed fund rate to 2.4 percent in 2018, 3.1 percent in 2019, and 3.4 percent in 2020. It does this through the Federal Open Market Committee meetings. Most FOMC members think conditions are robust enough to warrant it. Members are pleased with recent strong jobs reports. The current fed funds rate is 2.0 percent.
The Fed has been gradually raising rates since December 2015. That was the first rate increase since June 29, 2006. The rate had been at virtually zero (between 0 to 0.25 percent) 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 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 of those through its quantitative easing program.
Why the Fed Is Raising Rates Now
The Fed has been anxious to return rates to the healthy 2 percent level. It wants to get the economy out of a possible 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.
The Fed also wants to raise rates because it's been talking about it for more than a year. In response, forex traders expected the dollar's value to rise. To take advantage of that, they shorted the euro. That strengthened the dollar 25 percent in 2014 and 2015. The strong dollar hurt exports and slowed economic growth. It also created lower import prices. That reduced the chance of inflation. If people expect prices to stay the same or drop, they have less incentive to spend now. They know their purchase might cost less in the future.
Former Fed Chair Janet Yellen explained at the November 17, 2016, Congressional meeting that the Fed isn't affected by the election outcome. Federal Reserve Board Members look at economic data. But Donald Trump promised expansionary fiscal policies even though the economy was already growing at a healthy rate. The Tax Cuts and Jobs Act and increased spending will overheat the economy. As a result, the Fed must use contractionary monetary policy to prevent inflation.
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 percent to less than 1 percent. 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
Once the Fed raises the fed funds rate, how high will it go? The Fed expects to raise it to 2.4 percent in 2018, 3.1 percent in 2019, and 3.4 percent in 2020. The Fed forecasts inflation to remain between 2.0 to 2.3 percent until 2020. It will make sure that inflation is no worse than that. But there are five steps that will protect you from fed rate hikes.
Historically, the fed funds rate has remained between 2 and 5 percent. The highest it's ever been was 20 percent in 1981. The Fed raised it to combat an inflation rate of 12.9 percent. 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.