What the Fed Funds Rate Increase Means

On Wednesday, Federal Reserve Chairman Jerome Powell announced the Federal Open Market Committee will be raising their target rate to between 2.25% and 2.5%. This will be the fourth interest rate increase since he was appointed earlier this year.

The Fed Funds Rate is the interest rate which banks lend to one another in overnight transactions. The Federal Reserve is able to control this by altering their buying and selling patterns of U.S. Treasury bonds. By increasing or decreasing liquidity, the Federal Reserve has great control over interest rates. The Fed Fund Rate is typically the lowest rate offered with the Discount Rate, the rate banks may borrow directly from the Fed, being slightly higher.

The Fed Funds Rate remained at 0.25% between 2008 and 2015 to encourage more lending and an increased level of liquidity to borrowers. Janet Yeller, fearing potential inflation, raised the rate to 0.5% in 2015, 0.75% in 2016, and 1.5% in 2017 before stepping down. Pre-recession levels peaked at 5.25% in 2006. Interest rate increases are the most effective way to control inflation.

According to Yahoo, “the Fed’s latest dot plot now shows the FOMC’s median forecast calling for two rate hikes in 2019, down from three in September.” Fewer increases could mean we are nearing their peak target rate.

Interest rate increases are usually done for two reasons: 1) to curb inflation, and 2) to calm a boom. Inflation is projected to stay around 2%, their target, for the the near future. However, with a 10-year bull market, many economists believe a new recession may be on the horizon. Several indicators, including a flattening Yield Curve, point to 2019 as the next recession year.

A flattening Yield Curve means investors anticipate future interest returns on bonds to be lower in the future than today. The Fed only lowers these rates when fighting a recession, thus it is a valid predictor of future down turns.

If a recession were to occur, for monetary policy to work, the Fed would need to lower rates enough to spur growth. If they remained near zero, the Fed would be powerless.

Categories: Business

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