On Mar. 15, the Federal Reserve, the central bank of the United States, announced it was raising its interim benchmark interest rate by a quarter point (commonly referred to as 25 basis points), helping to stabilize the economy and influence the amount of interest increase banks and other institutions could apply to overnight lending money.
Past interest rates set by the Federal Reserve — often referred to as “the Fed” — have been at historic lows for years, but after the announcement of a 0.25% increase, the rate now sits at a range of 0.75% and 1.0%. In December, the Fed raised its interest rate by a quarter point, which was only the second increase since rates dropped almost to zero in 2008 in the wake of the financial crisis. So, why does the Fed adjust interest rates, and how can its decisions influence banks and other lending institutions?
The Fed does not have a set schedule for raising or lowering interest rates, rather, it adjusts them when it deems it necessary or advisable. Broadly speaking, interest rate adjustments tend to work as gas and brake pedals for the economy. When rates go down, people and businesses borrow more money. This tends to spur economic growth and employment, which is why rates were lowered drastically during the 2008 recession. However, if low rates are left unchecked, too much price inflation can occur. On the other hand, people and businesses tend to borrow less when rates go up, and as a result, the economy tends to slow down, which can help to keep inflation at bay and ensure that the market does not overheat.
Unemployment was down to 4.7% in February, while prices in January showed a 1.9% rise over the year before, which is very close to the Fed’s annual inflation target of 2%. Given those signs, the Fed increased interest rates as a way to tap the brakes and keep the economy’s growth stable and under control.
For banks and other lending institutions, the federal funds rate determines how much interest can be applied to money that they lend to other institutions overnight. By setting a benchmark interest rate for borrowing, the Fed is directly influencing market interest rates, such as the prime lending rate and short-term market rates like the London Interbank Offered Rate (LIBOR). These rates, in turn, can affect how much interest consumers pay on borrowed money.
Created in December 1913, the Fed is United States’ cash regulating backbone, providing stability and strength to the country’s monetary and financial system. In general, the Fed and has four priorities: 1) influence the economy in a way that encourages employment and stable prices, 2) regulate banks and other financial institutions to ensure the country’s financial system remains strong, 3) assess and address economic risk and 4) perform certain financial services for the nation’s government and financial institutions, as well as participate in the oversight of the country’s payment systems.
Click here to see how the interest rate has fluctuated over the past 40 years.