By: Siva Soorya
How will the rate hike in September and expected ones later this year affect you and the country? Let’s find out.
Following its widely expected decision to raise the federal funds target rate in the last week of September, the Federal Reserve not so surprisingly held the target rate steady in its November meeting. However, it signaled that it will stay the course and move rates up at a gradual pace in the coming months, with an additional hike in December, then three more in 2019 and finally one more in 2020. With jobs gains remaining strong, economic activity rising at a strong rate and inflation nearing its 2% target, the Fed remains confident that the U.S. economy will continue its positive growth over the next three years. Looking ahead, investors reacting to the Fed’s moves share a similar sentiment, with the Fed Funds Rate futures predicting an 80% chance of a December quarter-point move. Raising the target rate increases many interest rates on consumer and business loans and creates uncertainties in predicting how U.S. economic growth will move. What could some of these impacts be? Let’s find out:
In the United States, the federal funds rate is the interest rate at which banks and other financial depository institutions lend money to other depository institutions, on an uncollateralized basis overnight. After the 2008 financial crisis, the Fed began to differently utilize the fed funds rate as a monetary policy tool. Rather than setting a specific, target rate, it sets a target interval in which it would prefer the rate to float in. It remains a standard benchmark rate for most short term interest rates in the economy.
In an overheating economy, or one in which too much cheap and risky credit and money circulate, the Fed sets a higher range to “cool” or hinder more extension of such credit and money, thereby lowering inflation. In a sluggish economy, much like in 2009, the Fed sets a lower rate to boost economic growth and encourage the extension of more credit and money, leading to higher inflation.
In recent years, there has been a marked transition in the Fed’s economic outlook. It went from adopting an accommodative policy (low target range) to a more recent restrictive policy (high target range). With such changing policy sentiment and the latest rate hike, the U.S economy has had to adjust and react accordingly. We will discuss some of the latest developments below.
First, for an average American, the rate hike will drastically impact savings accounts. Because savings accounts’ payouts are linked with Fed rates, some top-yielding savings accounts (which usually give a return of 0.2 %) will now give returns as high as 2.25%. For example, with a savings rate, or annual percentage yield, of 0.2 %, a $10,000 deposit earns just $20 after one year. At 2.25 %, that same deposit would earn $225. So now can be a great time for Americans to open up a savings account.
On the flip side, the hike is going to impact the average U.S. consumer’s take home pay by causing wages not to rise as quickly as they have been from 2009 until now. This slowdown in wage growth typically reduces consumer spending and consumption in the general economy, and can hinder small and large businesses alike. There has also been a hike in long-term fixed mortgage rates, which are also linked with Fed rates. The prime rate in the economy, or the average rate given by banks to strong-credit consumers, has risen from the 3.75% in early 2016 to its current 5.25 % rate. Consumer consumption and demand for housing are two widely-used indicators for macroeconomic growth and stability. With higher fed rates, these two metrics are bound to adjust downward, making the average American less likely to spend on a new house or on another goods in the economy.
Michael Feorili, the U.S. Chief economist at Morgan Stanley,, had stated “there seems to be an unwillingness to signal a need to cool the economy down, and with each successive rate rise we are not seeing a whole lot of actual tightening. The risk is that they are not doing enough”. So, is the Fed actually doing enough right now? Should they clamp down with much tighter policies at present or wait until there is a drastic change in the job market which forces them to act? Well, there aren’t any easy answers to this conundrum. If anyone were to know the right course of action, then expect a call from the Fed in the coming days.
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