Policies enacted to provide pandemic relief have led to a major boom in the economy over the last two years. Stock market gains, hiring, and economic growth have all been high, but inflation has risen alongside them. In response, the Federal Reserve signaled in late January that it would begin raising interest rates this March.
Not sure what that means? Here’s everything you need to know.
First and foremost, what is the Federal Reserve?
The Federal Reserve, or the Fed, is America’s central bank. Two of its main goals include promoting employment and maintaining stable prices for consumer goods.
The Fed accomplishes its goals by conducting monetary policy, or controlling the availability and cost of money and credit.
In simpler terms, the Fed makes it easier or harder for individuals and businesses to borrow money, which affects spending habits and thus regulates the money supply. They do this by adjusting interest rates.
Wait, what are interest rates?
Interest rates are the amount charged by a lender for the use of their money. Here’s an example: Say you borrow $10,000 for one year and your lender charged you a 3% interest rate on your loan. You would end up repaying them a total of $10,300 at the end of the year. The extra $300 would be the interest you paid on your loan.
Interest rates also apply to commercial banks when they borrow money from each other or from their Federal Reserve accounts.
How does the Fed adjust these rates?
As the central bank of the United States, the Fed adjusts the interest rate at which commercial banks can borrow funds. By conducting what’s known as “expansionary” monetary policy, they can lower the interest rate and make loans cheaper. And by conducting the opposite—what’s called “contractionary” monetary policy—they can raise the interest rate and make it costlier for banks to borrow money.
This has a ripple effect on individuals and businesses, since in turn, commercial banks will make it easier or harder for them to borrow money too. And when borrowing becomes easier or harder, economic growth often speeds up or slows down.
Confused? Think about it this way.
When interest rates are low due to expansionary monetary policy, it costs less to take out a loan… so people and businesses tend to borrow more. Of course, the main reason you’d borrow money from a bank is to spend it on something: a house or a car if you’re an individual, an office or more employees if you’re a business. This increase in spending spurs economic growth.
However, when interest rates are high due to contractionary monetary policy, loans become more expensive. People and businesses start borrowing less money and thus spending less. Economic growth slows down as a result.
Got it! So why is the Fed raising interest rates this March?
Over the past two years, pandemic-related expansionary policies have resulted in an economic boom. But this growth in spending has created inflation, or an increase in the prices of goods and services due to the amount of money in circulation. In fact, the prices for many household goods are currently at a forty-year high.
Because one of the Fed’s aforementioned goals is to maintain stable prices, they’ve decided to conduct contractionary policy to reduce inflation. Hence the interest rate hike.
How will these higher interest rates affect me?
They could affect you in a couple of important ways. First, the Fed’s rate hikes could make it more expensive to borrow money over the next few years, something you should be aware of if you’re planning on buying a house or a car in that time. Businesses will also be more hesitant to invest in new offices and resources, and we’ll likely see a slowdown in hiring over the next few years.
Even if you aren’t planning to take out loans, you may still see the effects of these hikes in your day-to-day life. Since higher interest rates tend to slow inflation, you’ll probably see the prices of groceries, electronics, and other goods decrease and stabilize over the next few years.
Because the Federal Reserve’s monetary policies will impact your life in one way or another, it’s important to stay informed on what actions they’re taking and why. Be sure to keep an eye on interest rates over the next few months.