After meeting for two days, the Federal Reserve went through with an expected increase in the benchmark interest rate, which has now gone up 0.25 percent. Perhaps more surprising was how it mentioned its plans to decrease its balance sheet. Here’s what you need to know about the latest headlines coming out of the Federal Reserve.
A Background on the Benchmark Interest Rate
The Federal Reserve sets the benchmark interest rate to keep the economy strong. It likes to have that interest rate in the 2 to 5 percent range whenever possible, as that’s what’s best for economic growth. At that range, the gross domestic product (GDP) grows, the unemployment rate is low and while prices increase, they do so around the Federal Reserve’s desired inflation rate of 2 percent.
However, it hasn’t always been possible for the Federal Reserve to keep the benchmark interest rate between 2 and 5 percent. In 1979 and 1980, the Federal Reserve raised the benchmark interest rate to a historic high of 20 percent because inflation numbers had been in the double digits for most of the decade.
The benchmark interest rate fluctuated from then on but lowered considerably from that high point. It started dropping more in late 2007, and by 2008, it plummeted because of the Recession. The target rate by December 2008 was 0 to 0.25 percent, which is as low as it gets. The reason that this rate was a range instead of one percentage was because a rate of 0 percent could cause financial issues, such as money market funds with fees that cost more than what they yield.
The benchmark interest rate stayed in that range a full seven years, finally increasing again in December 2015. It went to the 0.25 to 0.5-percent range. One year later, it increased again, hitting 0.5 to 0.75 percent. The Federal Reserve chairperson, Janet Yellen, called this increase a vote of confidence in the U.S. economy. The Federal Reserve also mentioned at this time that it saw the rate increasing three times in 2017.
So far, the Federal Reserve has stayed on pace to hit those marks. An earlier increase this year brought the benchmark interest rate up to 0.75 to 1 percent, and this latest increase on June 14, 2017 brought it up to 1 to 1.25 percent.
What This Says About the Economy
Obviously, the fact that the Federal Reserve is consistently increasing the benchmark interest rate shows that the economy is gradually improving. The jobless rate has gone down quite a bit, and it’s now at 4.3 percent, but it should also continue to decrease. Inflation hit 2 percent early in 2017, although it then dropped back down a bit below that mark. The Federal Reserve isn’t particularly worried about this, though, as they believe that it will bounce back. One factor that has kept inflation down a bit is energy prices going down, and that may be temporary.
Now, for consumers, a higher benchmark interest rate means an increase in credit card and loan interest rates. While the increase hasn’t been anything huge, it does mean people can expect to start paying a bit more if they take out any loans. Just with the increases since December 2015, car loan and home equity rates have gone up about 1 percent.
The Federal Reserve’s Plan to Decrease Its Balance Sheet
This recent announcement was also when the Federal Reserve mentioned how it planned to reduce its balance sheet. During the Recession, the Federal Reserve purchased a large number of bonds, with the cost hitting the trillions of dollars. This was in response to the financial crisis. Bank lending had slowed down significantly, and by purchasing these bonds, the Federal Reserve was able to drive down the cost of borrowing.
This helped protect the economy to an extent, but it also obviously caused a huge increase in the Federal Reserve’s balance sheet. While that balance sheet was below the $1-trillion mark before the Recession, it ended up hitting about $4.5 trillion. Now that the economy is making a recovery, it’s time for the Federal Reserve to cut back on that, and it plan to do so to the tune of up to $600 million per year.
What Effect These Rate Increases Will Have
There have been some arguments regarding whether it’s a good idea to raise the benchmark interest rate. Those against it have mentioned that since the U.S. economy is still fragile while it recovers, making big moves or moving too quickly could each jeopardize the progress that has been made. There’s also the unstable global climate to consider, with Britain deciding to exit the European Union and China’s economy slowing down.
The Federal Reserve carefully monitors the economy, though, and to this point it has only made small increases in the benchmark interest rate. And the numbers are moving in the right direction. At the end of 2016, the unemployment rate was at 4.6 percent so it has gone down 0.3 percent in the last six months or so.
The Federal Reserve now has another six months to raise the benchmark interest rate again and hit its target of three increases in 2017. Most likely, another rate hike would bring it to 1.25 to 1.5 percent, since the Federal Reserve is playing it safe and avoid anything too significant at one time.
On the one hand, consumers who have gotten used to these rock-bottom interest rates will need to pay a bit more when they borrow because of these increases. But the good news is that this is all a positive sign regarding the economy and where it’s going. Ideally, over the next couple years the benchmark interest rate will gradually go back up until it returns to that 2 to 5 percent sweet spot. So, while it may cost a bit more to borrow, the stronger economy means people will have more money in the first place.