Demystifying Interest Rates: How the Federal Reserve Influences the Economy

I often receive questions on what interest rates are and why does the Federal Reserve change them. Interest rates impact many aspects of the economy, so it's important to have a basic understanding of how they work. ??

At its most basic, an interest rate is the cost of borrowing money. Banks and other financial institutions lend money and charge interest on the loans. The interest rate is the percentage of the loan that the borrower pays on top of repaying the amount borrowed. For example, if you take out a $100 loan at 5% interest, you will repay $105 - the original $100 plus 5% interest.

The Federal Reserve sets certain interest rates and influences many others. The main rate directly controlled by the Fed is called the federal funds rate. This is the rate banks charge each other for overnight loans. While it doesn't directly dictate consumer lending rates, changes to the federal funds rate influence other important rates like mortgage rates and bank prime rates. Typically, when the Fed raises rates, consumer borrowing costs tend to rise as well.

The Fed raises interest rates to keep inflation under control. Inflation means prices are rising across the economy. If spending and borrowing grow too fast, demand can outpace supply and raise prices. Moderate interest rate hikes make it more expensive to borrow and spend, slowing economic activity. This allows supply to catch up and helps control inflation. Lower rates do the opposite, boosting borrowing and economic growth.

Interest rates impact all kinds of borrowing costs that consumers and businesses rely on. Changes to rates also influence investment markets and the value of the U.S. dollar globally.

Here are the main interest rates controlled or influenced by the Federal Reserve:

• Federal Funds Rate: The interest rate banks charge each other for overnight lending. This key rate is directly set by the Federal Open Market Committee.
• Discount Rate: The interest rate the Fed charges banks to borrow from its discount window lending facility. This provides short-term liquidity to banks.
• Prime Rate: An interest rate that banks charge their most creditworthy customers. Though not directly set by the Fed, it tends to move in tandem with the federal funds rate.
• Mortgage Rates: Interest rates on home loans such as 30-year and 15-year mortgages. These are influenced indirectly by Fed policy changes to the federal funds rate.
• Savings & Money Market Rates: Interest rates set by banks on deposits and savings accounts. Tend to reflect prevailing federal funds rates and overall rate environment.
• Credit Card Rates: Interest rates charged by credit card issuers to cardholders. These tend to be variable rate products impacted by changes in the prime rate, which mirrors Fed policy moves.

That's why so much attention is paid to the Fed's decisions on interest rate policy. Small changes can impact employment, prices, wages, company profits, and more. The Federal Reserve is currently facing difficult decisions on interest rates. Policymakers have indicated that rates aren't likely to be lowered quite yet. However, with recent signs of slowing economic growth, most economists expect the Fed to adopt a more accommodating policy stance by mid-year. This could mean beginning to cut rates around June, unless inflation unexpectedly accelerates.

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