Here's how the Fed raises interest rates

Banks give out money all the time, but for a fee.

When we borrow and then pay back with interest, it’s how they make money.

The cost of borrowing — interest rates — make a big difference on which credit card you choose, or whether you get an extra one at all.

If your bank wants to make it more expensive to borrow, it’s not as simple as just slapping on a new rate, like a grocer would with milk. That’s something controlled higher up by the Federal Reserve, America’s central bank.

Why does the Fed care about interest rates?

In 1977, Congress gave the Federal Reserve two main tasks: keep the prices of things Americans buy stable, and create labour-market conditions that provide jobs for all the people who want one.

The Fed has developed a toolkit to achieve these two goals of inflation and maximum employment. But interest-rate changes make the most headlines, perhaps because they have a swift impact on how much we pay for credit cards and other short-term loans.

From Washington, the Fed adjusts interest rates to spur all sorts of other changes in the economy. If it wants to encourage consumers to borrow so that spending can increase, which should help the economy, it cuts rates and makes borrowing cheap. When people are spending like crazy, it raises rates so that an extra credit card suddenly doesn’t seem very desirable.

Samantha Lee/Business InsiderYellen explaining the rate hike in December 2016.

Most of the time, the Fed adjusts rates to respond to inflation — the increase in prices that happens when people borrow so much that they have much more to spend than what’s available to buy.

However, what the Fed is doing right now is a bit unusual.

”This is the first tightening cycle where they have been concerned about inflation being too low,” Alan Levenson, chief economist at T. Rowe Price, told Business Insider.

The Fed’s preferred measure of inflation last touched its 2% target in 2012. And so, the Fed can’t exactly argue that it is raising rates to fight inflation, although it expects prices to rise.

So how do rates go up or down?

Banks don’t only lend to consumers; they lend to each other as well.

That’s because at the end of every day, they need to have a certain amount of capital in their reserves. As we spend money, that balance fluctuates, and so a bank may need to borrow overnight to meet the minimum capital requirement.

And just like they charge you for a loan, they charge each other. The Fed tries to influence that charge, called the federal funds rate, and is what they’re targeting when they raise or cut rates. When the fed funds rate rises, banks also hike the rates they charge consumers, and so borrowing costs increase across the economy.

Floor and ceiling

After the Great Recession, the Fed bought an unprecedented amount of Treasurys to inject cash into banks’ accounts. And so, there’s now over $US2 trillion in excess reserves parked at the Fed; there was less than $US500 billion in 2008.

It figured that one way to pare down these Treasurys was to lend some to money-market mutual funds and other dealers. It does this in transactions known as reverse repurchase operations that basically involve selling the Treasurys and agreeing to buy them back the following day.

The Fed sets a lower, ‘floor’ rate on these so-called repos.

And then, it sets a higher rate that controls how much it pays banks to hold their cash, known as interest on excess reserves. This acts as a ceiling since banks won’t want to lend to each other at a rate lower than what the Fed is paying them, at least in theory.

In December, the Fed decided to set the repo rate at 0.50% and the IOER rate at 0.75%. With the 25 basis-point increase expected on Wednesday, March 15, the new ‘floor’ repo rate becomes 0.75%, and the ceiling 1.00%.

The effective federal funds rate, which is what banks use to lend to each other, will then float somewhere between 0.75% and 1.00%.

When the Fed raises rates, banks are less incentivized to lend since they are earning more to park their cash in reserves. That reduces the supply of money and raises its price.

But I’m not a bank

After the Fed has successfully lifted the funds rate, the baton gets passed on to banks.

Banks first raise the rate they charge their most creditworthy clients like large corporations, known as the prime rate. Usually, banks announce this hike a few days after the Fed’s announcement.

Things like mortgages and credit cards rates then get benchmarked off the prime rate.

“The effect of a rate hike is going to be felt most immediately on credit cards and home equity lines of credit, where the quarter-point rate hike will show up typically within 60 days,” Greg McBride, the chief financial analyst at Bankrate.com, told Business Insider.

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