HONOLULU (KHON2) — With news about interest rates rising and falling, it’s common to feel confused about what that could mean for the average person and their everyday life.
While there’s a bit of economic jargon and processes that go into explaining interest rates, it doesn’t have to be intimidating.
What is the federal interest rate?
The federal interest rate, also known as the federal funds rate or Fed rate, is the interest that banks pay each other when they borrow money from each other.
No bank has an infinite amount of money — even if banks have a large stockpile of cash, known as a reserve, their need may exceed the amount of money they need to conduct their daily business.
So, banks borrow from other banks, which the government sets the interest rate for these inter-bank transactions.
The interest rate charged on these transactions can influence everyday consumer costs, such as credit card fees or mortgages. When the federal interest rate goes up, your credit card or other loan rates mirror that, and vice versa when the rate goes down.
Banks looking to make a profit off their services will charge consumers higher interest rates than what the federal interest rate is, but the Fed rate is still a good indicator on how your personal rates may fluctuate.
Economists often describe the economy as a bubble. Bubbles can only grow so big before they pop, with factors like a low interest rate inflating the bubble before it pops with high interest rates.
Who determines the federal interest rate?
The federal interest rate is determined by the Federal Reserve System, which is commonly referred to simply as “Federal Reserve” or “The Fed.” The body acts as the central banking system of the country, and was established more than a century ago in 1913.
More specifically, the Federal Reserve’s Federal Open Market Committee decides the appropriate interest rate by analyzing economic dats, reports, surveys and more from financial institutions, consumers and other sources.
The committee is composed of Federal Reserve board members, the president of the New York Fed and four regional Federal Reserve presidents.
While some politicians may say they are going to raise or lower interest rates, they do not have direct control over the rate, only the committee possesses that power.
For more information on the makeup of the committee and purpose of the rate, visit the Federal Reserve’s website.
Why does the Fed rate increase?
The Federal Open Market Committee typically increases the Fed rate to help combat inflation.
The thinking behind this is as follows:
- When the country has an inflation problem, that means that prices are exceptionally high.
- By raising the interest rate, banks have to pay more on inter-bank transfers.
- This cost is passed down to the consumer by raising their interest rates.
- Consumers will be less incentivized to spend money due to the high interest rates.
- Theoretically, companies will see that consumers are spending less and lower their prices to attract consumers once again, helping curb inflation.
As a result of an increase, credit card interest, mortgage rates, car loans or any other type of transaction with a financial institution will also go up.
Why does the Fed rate decrease?
The Federal Reserve’s committee will decrease rates out of concern for the economy. When consumers are hesitant to spend or are not spending money at previous rates, the government wants to incentivize spending.
In turn, the Fed rate is decreased, allowing individuals more financial flexibility with their spending. Credit card rates are lowered, as well as home and auto loans, among other things.
These lowered rates encourage the spending, as consumers typically would prefer to pay less interest, especially on big-ticket purchases like a new home or their dream car.
The job market also plays a decent role in the decrease of rates. When less people are working, less people have money to spend as they do not have a reliable income stream, meaning the Fed is likely to cut their rate.
For more information on varying interest rates and historical graph, visit NerdWallet.
Ultimately, the Federal Reserve is able to analyze the economy and make whatever call the committee deems appropriate. When the country’s economy is slowing, officials look to speed it up a little with lower rates. Conversely, when the economy is moving a bit too fast, the committee slows it down with higher rates, which creates a cycle of constantly changing rates as the economy fluctuates.