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The Federal Reserve Interest Rate Decision and How It Affects You

Updated on January 18, 2016

Introduction

The Federal Reserve, through its interest rates, sets the benchmark for the cost of borrowing money for everyone in the United States, from house mortgage to industries.

If there is too much money in the economy, then the prices for goods and services rise. Because there is so much money to go around, everyone raises prices on their products. This is called inflation and can be harmful, particularly to the poorest members of society. To combat this, the "Fed" (as the Federal Reserve is commonly known) increases interest rates and reduces the amount of money in circulation.

If there is too little money to go around (liquidity crunch), then people do not have the money necessary to buy goods and services and it disrupts the economy. In these instances, the Fed deceases the interest rates to increase the money supply, thus enabling people and industries to borrow money in order to produce and to consume. These two tools (raising and lowering interest rates) allow the Fed to keep the economy healthy.

2008 Interest Rate Reduction

The crash in the credit market along with the housing market in 2008-09, caused the Federal Reserve to cut its interest rates to zero. This meant that there was little benefit to saving your money (because it would gain very little interest in the bank) and it made the cost of borrowing money very little. This encouraged people to seek loans so that they could invest money. The Fed was attempting to encourage people to obtain and spend money.

This in turn helped Industries and enterprises to borrow from the banks at a very low interest rates, helping them to manufacture goods and provide services, thereby creating jobs and enabling the people to earn a living, to consume goods and services. The low interest rates also helped the people to buy homes thereby fueling the housing market and all of the associated goods and jobs.

Federal Interest rates from 2000 to 2013
Federal Interest rates from 2000 to 2013

2015 Interest Rate Hike

In December 2015, the Fed raised its interest rates to 0.25%. The 7 year period of 0.0% was unprecedented. The eventual raise in rates was based on the strengthening economy. For instance, there had been significant growth in the job market. Additionally, the Fed was beginning to be worried with looming inflation. However the financial markets are very volatile and also the Central Banks of Europe and Japan are cutting their interest rates to stimulate their own economies.

Will the Fed keep increasing interest rates?

As per the Chicago Mercantile Exchange, the futures market place a probability of 65% that the Fed will not increase it's interest rates in it's March 15-16 meeting. According to a survey conducted by The Economic Times of the 51 leading economists, Fed will likely increase its interest rates to 11.0% by 2017.

However, such an increase in the interest rates would be monitored closely for its effects on the economy and whether the Market can absorb the hike. Any increase in Interest rates would cause the cost of borrowing to rise that is the prime rate, the house mortgage rates, the car loan rate and the credit rate, but would help the people with money in the bank since an increase in the interest rates increases the bank savings rate.

An increase in the interest rates could lead to reduction in consumer spending, home sales, car sales thereby fall in company's profits. An increase in interest rates also makes the dollar stronger thereby making exports expensive and coupled with a weak global demand would lead to lower exports. Imports however become cheaper aided by a strong dollar and low global commodity prices, but low import prices also have a tendency to stifle local industries.

Thus the Federal Reserve performs a balancing act by changing its interest rates to keep the American economy even and ensure the healthy growth of the economy. Even though there are different opinions on when and how much the Fed will raise rates, everyone agrees that it will be done slowly and very carefully.

Janet Yellen (head of the Federal Reserve) decides whether or not the interest rates rise.
Janet Yellen (head of the Federal Reserve) decides whether or not the interest rates rise.

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Conclusion

Even though interest rates have ticked up slightly, there is still little incentive to leave too much in a savings account or CD. Unfortunately, the Chinese stock markets are also suffering and the global markets are feeling the impacts. The US stock market is suffering the first "correction" in many years. Although unemployment is down and minimum wages are rising, there is still quite a lot of uncertainty in the US economy.

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