When banks lend us money and we eventually have to return the money, that is the way in which they generate more money – through the interest they are charging us.
The cost of these loans, known as the interest rate, can make a big difference depending on the type of loan you choose, a mortgage loan is not the same as a credit card for example.
But if it costs more (or less) for the bank to lend money, and more(or less) for you to borrow money, regardless of the type of loan or your credit, then that is something being controlled from a higher institution – the Federal Reserve Bank aka the FED.
How does the rise in interest rates affect our pockets?
Why does the Fed care about interest rates?
In 1977, the Congress of the United States, entrusted the Fed with two main tasks:
- Maintain stable prices for the things that US citizens are buying.
- Create conditions in the labor market that provide jobs for United States citizens.
The Fed has developed a set of strategies and tools to achieve the two objectives of controlling inflation and maximizing the employment market. But changes in interest rates always occupy the most attention, perhaps because it has an immediate effect on whether we pay more or less for our loans and credit cards.
The Fed adjusts interest rates to drive changes in the US economy. If you want to promote economic growth and encourage consumers to borrow so that spending increases, you reduce interest rates and make loans cheaper.
To achieve the opposite effect, and head off inflation, increase interest rates, so that loans and credit cards are more expensive.
Therefore, in short, the Fed adjusts interest rates in response to inflation, the increase in prices that happens when citizens have more resources to consume than what is available to be purchased.
At this time, the Fed is not raising interest rates to offset inflation, although it thinks prices will rise. This means that decisions always revolve around the forecasts for economic growth and future increases in interest rates.
So, what influences the increases or decreases of what banks are charging?
Banking entities do not only lend to their clients, but they also lend amongst themselves to other banks. This is because at the end of each day, they need to have a certain amount of money in their reserves.
Therefore, as we spend money that we have stored in a bank, that balance fluctuates, so the bank may have to borrow money during closing and opening the next day to meet the minimum capital requirement that the regulators demand. And they therefore charge each other interest to lend money back and forth.
The Fed tries to influence what type of commission charged, called the federal funds rates, and that is what it aims for when interest rates rise or fall. When the federal funds rate grows, banks also increase the interest charged to consumers, so the costs of getting into debt increases throughout the economy.
The Fed establishes a rate for banking entities to lend to each other
After 1929, the Fed bought a large amount of Treasury bonds to inject cash into the accounts of banking entities. Around $2 trillion dollars in excess reserves are now deposited in the Fed, in 2008 there were less than $500 billion dollars.
A way to decrease these bonds is to lend money to the mutual funds of the market as well as other participants. The Fed usually does so through transactions called reverse repurchase transactions, which involve selling the Treasury bonds and agreeing to buy them the next day.
Then it establishes a higher interest rate that controls how much it pays banks to keep their cash, which is known as interest on excess reserves. This acts as a ceiling, because in theory banks will not want to lend to each other at a lower interest rate than the one the Fed is paying them.
In March 2018, when the Fed raised interest rates, it set the repurchase rate at 1.50 percent and the interest rate for surplus reserves at 1.75 percent. An increase of 0.25 percent, establishing the new rate at 1.75 percent and the ceiling at 2 percent.
Therefore, the effective type of federal funds, which is what banks use to lend money to each other, fluctuated between the target range of 1.75 and 2 percent. That is, when the Fed increases rates, banks are less incentivized to lend, as they are earning more to save that cash in their reserves. This is a key point.
The Fed has increased the IOER (interest rate on excess reserves) by 0.20 percent instead of 0.25 percent. This is because reference funds are at 1.7 percent, close to the ceiling of 1.75 percent. Therefore, the Fed has made a small adjustment to give some protection in case they get too close to the established ceiling.
I am not a bank, how will all this affect me?
After the Fed increases the federal funds rate, the next step is for banks to pass it on to consumers.
The banking entities first increase the interest rate charged to their more solvent clients, which is usually the large companies, something that is denominated as the preferential interest rate. In general, banks announce this increase a few days after the Fed has done so.
Products such as mortgage loans and interest on credit cards are compared to the preferential interest rate. The effect of an increase in interest rates is automatically passed on to credit cards and home equity lines of credit, where the increase in interest rates, for example by 0.25 percent, appears at 60 days.
The increase in interest rates has already been noted in the housing market, since mortgage interest rates are increasing in a situation in which the housing inventory is low. The average fixed rate for a 30-year mortgage in the United States is 4.49 percent, in contrast to 3.85 percent at the beginning of 2018.
In short, how does this affect you? High interest rates are beneficial for savers as banks increase interest payments on deposits.