The Fed Is Raising Interest Rates, Here's How It Will Impact You

The Federal Reserve announced a modest increase in interest rates on Wednesday that will precede three additional hikes in 2017, a move that has been expected since August and signals greater confidence in the strength of the U.S. economy while counteracting signs of rising inflation.

The Fed will raise the federal funds rate — which is the rate banks charge each other to borrow overnight — by a quarter point from a range of 0.25 to 0.5 percent to between 0.5 and 0.75 percent. Following the three planned rate hikes, the federal funds rate is expected to be near a target of 1.4 percent by the end of the year.

While that may not sound like much, rising interest rates can have a significant impact on borrowers who take out loans to buy homes or cars, finance their education, or carry a credit card balance, because those interest rates rise along with the federal funds rate. For example, if the rate rose from 0.41 percent (where it is today) to 1.4 percent as planned, and the spread between that rate and the 30-year mortgage rate stays constant, monthly payments on a new $200,000 mortgage would increase by $123 between today and the end of 2017.

How does the Fed raise or lower interest rates?

The main tool that the Fed uses to affect interest rates is through what are called "open market operations" — which is economist-speak for the buying and selling of U.S. bonds to control the supply of money.

If the Fed wants to accelerate economic growth, it buys bonds, which lowers interest rates. Conversely, if slower growth is more desirable (like when there’s excessive inflation), the Fed sells bonds to reduce the supply of money in the economy and interest rates rise.

To be clear, the Fed doesn’t directly control the interest rate — financial markets do. But the Fed uses open market operations to indirectly influence the federal funds rate.

What does this mean for the economy?

In general, it should be seen as a positive for the U.S. economy that the Fed is raising interest rates — though it could slow the pace of borrowing. Following the financial crisis and recession that rocked the American and global economy in 2008, interest rates have been at or near historic lows to make it easier for businesses and individuals to invest and drive an economic recovery.

Federal Reserve Chairwoman Janet Yellen explained the decision to increase rates, saying,"My colleagues and I are recognizing the considerable progress the economy has made toward our dual objectives of maximum employment and price stability."

When asked, Yellen declined to comment on the level of stock prices with markets reaching all-time highs in recent weeks, saying only that valuations remain within normal ranges. The Fed has been accused of making policy decisions to boost stock markets in the past, so Yellen likely wanted to avoid implying that the Fed took that into account when planning its interest rate hikes. The major U.S. indexes — the Dow Jones, S&P 500 and Nasdaq — all closed between 0.5 and 0.81 percent down on Wednesday.

— Eric Revell

(Photo Credit: Flickr user Speaker resources)