When the Federal Reserve (Fed) raises or lowers interest rates a chain reaction is set into motion. It’s like the domino effect. The Fed is the first domino and whatever they do -- creates the chain reaction. If the fed raises interest rates, banks raise their prime rate, which in turn affects mortgage rates, car loans, business loans, and other consumer loans. However, a bank can raise or lower their prime rate without the FED making the first move. It is uncommon for most banks to change their prime rate without the fed making the first move -- but it does happen.
Lower interest rates usually spur the economy by making corporate and consumer borrowing easier. Higher interest rates are intended to slow down the economy by making borrowing harder.
Think about it this way: If interest rates increased from 6% to 14% what do you think would happen in the area of home mortgages? Naturally, less people would be buying or building homes, and the sale of building supplies would decrease. Make sense? If interest rates decreased from 14% to 6% what do you think would happen? People would be storming the banks in a rush to borrow "cheap" money to build new homes, buy cars, and invest in their business.
Let me define a few of the common terms used in the media:
1. Federal Funds Rate: The interest rate (controlled by the Fed) which banks charge each other on overnight loans. This is usually the rate that the Fed keeps adjusting.
2. Discount Rate: The interest rate charged by the Fed on its own loans to banks.
3. Prime Rate: the interest rate banks give their best customers and has a direct effect on other rates for mortgages and car loans. When the Fed raises or lowers the interest rate, most banks follow by changing their prime rate. Some respond by raising their prime rates only minutes after the announcement.
4. Inflation: Inflation takes place when you have to spend more money to buy services or goods -- than you used to. Inflation takes place when you have too much money chasing after too few goods! The Fed raises and lowers interest rates to help keep inflation under control. Restricting the amount of money available to people is one tool the Fed uses to keep inflation under control.
Let me illustrate the most common effects of the Fed changing interest rates:
| When the Fed
Interest Rates You Can "Expect"
| When the Fed
Interest Rates You Can "Expect"
|Car Loan Rate||HIGHER||LOWER|
|Money Market Rates||HIGHER||LOWER|
|Credit Card Rates||HIGHER||LOWER|
Why does the Fed lower or raise rates?
The Fed is trying to maintain a "healthy" economy. If the economy is "very slow" the Fed might decide to lower interest rates that will in turn make money more available to businesses, home buyers, and consumers. If the economy is "heating up" and in the opinion of the Fed -- growing too quickly, they will raise interest rates to "slow things down".
The Merry-Go-Round Illustration
Merry-go-rounds are fun to ride if they are going the right speed -- not too slow or too fast! Imagine that a merry-go-round represents our economy. Imagine with me the Fed represents the person at the controls of the merry-go-round. If the merry-go-round is going too slow, it‘s the job of the Federal Reserve to help pick up the speed by moving a few levers (interest rates would be one example) so that the maximum number of people can enjoy the ride.
If the merry-go-round is moving too fast, it’s the job of the Federal Reserve to move a few levers, gently applying the brakes and help slow it down. If the merry-go-round is going too fast some people might be enjoying the ride -- but eventually people are going to start getting sick -- be thrown off the ride -- have to go to the hospital -- and some might die. Plus, the machinery running the merry-go-round might begin to overheat and eventually stop working. If that happens no one will be able to enjoy the ride anymore!
In merry-go-round terms -- it’s the job of the Federal Reserve Board to give the majority of the people a pleasant ride. Not everyone will always be happy. Some will want to keep the ride going fast, others like it slow, but the role of the Federal Reserve is to do what is best for the overall economy.
What is the goal of the Federal Reserve?
The Federal Reserve was commissioned to be sure our banking system remains sound and to keep our economy healthy. The Fed tries to keep our economy from experiencing boom and bust "extremes".
Why Is "Rapid Growth" Not Good For The Economy?
Steady growth is good! But too much growth "too fast" is not good. I have thought for a long time about how to explain this. Let me try it this way:
You own an ice cream business. On an average business day you have about 200 customers coming to your store buying your ice cream. One morning you show up and 2000 people are standing outside your door wanting to buy ice cream. After your initial panic and excitement, you and your one employee begin serving the customers. By mid-morning you have even begun the process of ordering additional ice cream to be delivered by an express ice cream truck. Because of the long line, some of your ice cream customers will be mad and leave, but you faithfully keep serving those in line.
You think to yourself, "Life is great and the ice cream economy is booming!" In fact, for the next seven days, 2,000 people are standing in line to buy your ice cream. Due to the high demand, increased expenses and the obvious ample supply of money in your community, you decide to raise the price. This is what we would call inflation. You have inflation when too much money is chasing after too few products. Remember, inflation is one of the things the Federal Reserve is trying to avoid.
Let’s say next week the demand for ice cream is back to normal, about 200 people a day. What if you had already put on the payroll eight more employees to serve your customers? What if you had increased your ice cream order 10 times the normal amount? What if the ice cream supplier had already delivered your ice cream? What if you had already signed a new lease to triple the square footage for your ice cream store?
With the decrease in demand for ice cream, the only thing you could do would be to start handing out pink slips to several of your employees. You would also have to deal with a massive surplus of ice cream in your storage. In addition, you would have a large amount of your money tied up for a long time in inventory because it might take you months to sell all the ice cream you ordered.
In simplistic terms, this is exactly what the Federal Reserve is trying to avoid. They are controlling the availability of money by raising and lowering interest rates so that 2000 people will not show up at your ice cream store. The Fed and you would rather see "steady growth". And steady growth (not rapid growth) is good for the economy!
Who appoints the Federal Reserve Board Members?
Congress established the Federal Reserve in 1913. The Board of Governors has seven members who are nominated by the President of the United States. The Senate confirms the nominations and each board members serves for a 14 year term. The chairman is appointed by the President, confirmed by the Senate and serves a four year term, and can be re-appointed.
What is the Federal Open Market Committee?
This committee meets eight times each year to adjust (if necessary) the federal funds rate and the federal discount rate. It is made up of the seven board members, the president of the Federal Reserve Bank of New York, and four other presidents (from the other 11 Federal Reserve Banks).
In these meetings they discuss trends in: housing, inflation, wages, employment, construction, inventories, business investments, foreign economic issues, consumer income, consumer spending and interest rates.
After discussion they decide if interest rates or economic policies need to be adjusted so that the economy remains stable and people are enjoying the ride! As mentioned earlier, the most common adjustment is to change the Federal Funds Rate: the interest rate which banks charge each other on overnight loans.
Is the Federal Reserve Controlled by the Government?
The Fed is commissioned by Congress, but is independent in its decision making policies. The Fed was not designed to be a political tool, therefore it has to be independent from the government. Yet, Congress can change how it operates at any time! The chairman gives reports and answers questions to Congress twice a year.
It is the responsibility of the Fed to implement policies that will help to maintain good economic health for our country. One of the primary tools the Fed uses is interest rates -- which have a direct impact on the direction of our economy. Decreasing interest rates will cause economic growth and increasing interest rates will cause the economy to slow down.
A Biblical Perspective
Some of you might be thinking, "Why do I need to understand what happens when the Fed raises or lowers interest rates? Who cares?" As a steward and manager over the financial resources God has entrusted to you -- you should care! For example, the overall direction of our economy affects the return on your investments, your potential for charitable contributions, and if you have a mortgage payment, how much you are paying each month. Developing an overall understanding of the economy will be beneficial in making financial decisions. Don’t be like the servant who was lazy and went out and buried his talent (Matthew 25). Seek to understand the economy in which you live. Seek to properly invest the resources God has entrusted to you. Seek to avoid having to pay higher interest. Seek to have a basic knowledge of how interest rates work and how the stock market works. Seek to be a good and faithful steward!
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© copyright - 2000, Ethan Pope