Why do interest rates matter?
The next Federal Reserve FOMC meeting is scheduled for Oct. 27-28th and it's good to understand why these meetings are important. The FOMC meets eight times per year (approximately every six weeks) and their interest rate decisions influence borrowing costs and spending considerations for American households and businesses.
Lower interest rates, for example, often encourage more people to obtain a mortgage, borrow money for an automobile or home improvements. Lower rates also can encourage businesses to borrow funds to invest in expansion, such as purchasing new equipment, updating plants, or hiring more workers. Conversely, higher interest rates can restrain such borrowing by consumers and businesses, which can prevent excesses from building in the economy.
The Federal Reserve policymakers on the Federal Open Market Committee seek to set interest rates that create the conditions needed to achieve the mandate given by Congress: to promote maximum employment and stable prices.
Most people hear about the Federal Reserve the same way they hear about the weather: “The Fed raised rates again,” or “The Fed is likely to cut this year.” Usually, the announcement passes across the screen, and life goes on. However, this time around, due a tense and polarized political situation, monetary policy has taken center stage. President Trump urged the Federal Reserve to cut rates “yesterday,” so to speak, to stimulate economic activity. He is convinced that the economy does not have any more inflationary pressure and that keeping federal interest rates at the present level is simply a political decision of his opponents to stall his economic agenda.
Ordinary people though generally fall into three camps: those who are in favor of a rate cut, those who are against it, and those who are indifferent.
What is the federal interest rate anyway, and how does it affect the daily life of ordinary people? When you hear “the Fed raised (or cut) interest rates,” what actually changes is a concrete price: the rate at which banks lend to one another overnight, known as the federal funds rate. The Fed announces a target range for that rate and then uses its tools to keep the market rate inside that corridor. It can also buy or sell longer-term securities, such as Treasury bonds and mortgage-backed securities, to push longer-term rates up or down. It is worth mentioning that overnight lending between banks is a routine operation, as every day brings different balances for banks, and they must maintain a certain level of liquidity in accordance with regulatory requirements. Banks that are short of reserves borrow funds from those that have an excess.
None of this directly or immediately changes the 30-year mortgage rate. But it does change the starting point of the entire interest rate structure. When the Fed raises short-term rates and signals that it will hold money “tighter” for some time, banks’ funding costs rise, Treasury yields tend to rise, and investors demand greater compensation for holding long-term debt. Mortgage rates, corporate bond yields, and many business loans are priced as “Treasury yield plus a spread.” When the fundamentals change, the entire structure changes. A loose monetary policy would shift the entire interest rate structure in the opposite direction.
At each policy meeting, the Fed publishes a brief statement explaining why it moved rates or why it chose not to. The official justification almost always refers to two numbers: inflation and unemployment. By law, the Fed has a dual mandate: to pursue “maximum employment” and “stable prices.” In practice, this means lowering interest rates during difficult times, raising them when inflation is too high, and hoping that the economy will respond correctly during this cycle.
Once the Federal Open Market Committee (FOMC) adjusts the target range for the federal funds rate, the Federal Reserve uses its monetary policy tools to implement, or carry out, the new stance of policy. In other words, the Fed uses its tools to ensure that market interest rates, especially the federal funds rate, move in the direction of the new target range. This helps steer the economy toward the Fed’s dual mandate goals.