Ever wonder how the Fed's interest rate actually works?
asserted
rate → wonder → ?
We've got answers
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We → get → answers
And on Wednesday, the Fed wielded it for the first time this year, raising rates by a quarter percentage point in a bid to slow down accelerating inflation.
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Fed → wield → inflation
But what does it mean when the Fed raises — or lowers — rates?
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Fed → mean → rates
And how does that affect the economy and all of us?
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that → affect → us
Here's how to understand it all.
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understand → understand → it
So what does the Fed actually do?
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Fed → do → what
The Fed really has two main jobs.
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Fed → have → jobs
The first is to ensure that prices remain stable, which generally means inflation that is neither too hot, nor too cold.
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that → ensure → inflation
The second job is to strive for an economy with maximum employment — meaning ensuring the labor market is growing at a healthy pace and people who want jobs can find them.
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who → strive → them
There are times when things are clicking in the economy and both of the two Fed mandates are at peace with each other.
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both → be → other
Inflation is just at the right temperature, meaning everyday prices are not rising too much, while the labor market is growing steadily, meaning people who want work can find them.
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who → mean → them
But more often than not, the Fed finds itself in a situation where it has to focus on one of the two — or worse: Both inflation and the labor market are flashing warning signs and policy makers have to confront the agonizing choice of which one to focus on first.
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makers → find → one
So how does the Fed accomplish its goals?
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Fed → accomplish → goals
The Fed has several tools at its disposal to try to influence the economy — but none is more important than the interest rate.
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none → have → rate
When inflation is running hot, the Fed typically springs into action by raising interest rates — just like it did this week.
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it → run → rates
Although the Fed doesn't directly control what firms charge for mortgages or credit cards, it's hoping that by raising its own interest rate, it can lead to a domino effect across the economy that can then push up many kinds of borrowing costs across the economy.
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that → control → economy
It's the equivalent of applying the brakes on the economy.
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It → apply → economy
The main goal is to try to cool down prices by trying to get people and businesses to think more carefully about their spending.
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people → try → spending
People might think a little harder about whether to buy a home if mortgage rates are higher — or whether to take that business loan if banks are charging more.
uncertain
banks → think → more
On the flip side, when the Fed is concerned about the labor market and wants to push up economic activity, it cuts interest rates in the hopes that the opposite will happen.
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opposite → concern → hopes
It's the equivalent of trying to press on the accelerator for the economy.
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It → try → economy
Take what happened during the Covid-19 pandemic— the Fed, then led by Jerome Powell, was concerned that the pandemic would lead to massive layoffs.
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pandemic → take → layoffs
So Powell and the Fed slashed interest rates to near zero, hoping it would spur financial firms to charge less for loans or mortgages — and thus encourage more spending across the economy.
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it → slash → economy
It worked — until inflation began climbing and then the Fed had to do the opposite and start cutting rates.
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Fed → work → rates
So why is the Fed raising interest rates now?
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Fed → raise → rates
As Fed Chair Kevin Warsh said Wednesday, "The plain fact is that inflation is too high and has been for too long."
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inflation → say → long
Inflation has run above the Fed's 2% target for five years, and the central bank is not confident it would cool off without higher interest rates.
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it → run → rates
Warsh also made the case that it's the right moment to act with the economy strong enough to absorb the impact of what is ultimately a modest interest rate hike.
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what → make → impact
Consumer spending has been growing even as higher prices continue to pinch many households.
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prices → grow → households
And the job market appears to be on solid footing to weather higher borrowing costs without triggering a surge in layoffs.
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market → appear → layoffs
So what happens now in the economy – and our pocketbooks?
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what → happen → economy
The Fed's rate hike is small enough that it shouldn't have a dramatic effect — but it does come as many borrowing costs are already rising, partly in anticipation of higher interest rates.
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costs → have → rates
The average rate for a 30-year fixed rate mortgage jumped to 6.95% this week, almost two-tenths of a percent higher than a week earlier, according to mortgage giant Freddie Mac data out on Thursday.
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rate → fix → Thursday
That's enough to increase the cost of a standard home loan by hundreds of dollars each month and further stall hopes of a recovery for the country's stagnant housing market.
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That → increase → market
"It's like that Godfather movie," said Kara Ng, senior economist at the real estate company Zillow.
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Ng → say → company
"Everytime it tries to break out, something pulls it back in."
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something → try → it
A higher interest rate also trickles down to the cost of carrying a balance on a credit card or a Buy Now Pay Later deal, though the moves are not as substantial as with mortgages.
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moves → trickle → mortgages
Analysts at LendingTree, an online loan marketplace, estimate that for someone with $7,000 in credit card debt, the Fed's rate hike would cost just a few extra dollars each month.
But these higher borrowing costs come as Americans have already been struggling with the high cost of living.
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Americans → estimate → living
The Fed, though, is hoping that the added near-term pain to households will be worth it if it can eventually help bring down inflation.
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it → hop → inflation
…and 4 more, not listed.
The Aporia
