There has been a lot of talk lately about if the Federal Reserve will continue to raise the Federal Funds Rate, which is used as the base for all short-term interest rates. The Federal Reserve (Fed), raised rates when they met back in December. This was significant because the Federal Funds Rate (FFR) has been at almost zero for nearly a decade.
The FFR was dropped from 5.26% in July of 2007, to .15% in January of 2009. Because the FFR is the base for every other short-term interest rate, this meant that interest rates on car loans, credit cards, student loans, etc. went down. This drop, and the fact that the Fed can drop or raise interest rates on demand, may lead many to ask what purpose these actions may serve. Why would the Fed raise interest rates in the first place and why would they drop them at the beginning of the Great Recession?
First, we need to recognize that the FFR is one of the Fed’s most effective tools for monetary policy. Chiefly, the FFR gives the Fed a way to combat, or increase, inflation. Currently, the Fed has a target inflation of 2%, serving as an incentive to get people to purchase something today instead of tomorrow. For instance, why buy a $1,000 computer today? Well if you know that due to inflation, the price will by $1,002 next year then you will buy it today instead of waiting. The higher the price of a thing the more you save; but nevertheless, a moderate amount of inflation stimulates consumer spending.
Now that we know that a limited amount of inflation is beneficiary to the economy as a whole, we can understand how the Fed uses the FFR to manipulate inflation. Low interest rates, which are produced by a low FFR, incentivize both people and businesses to purchase things. If people begin to purchase more than is in supply, the price of a good goes up, inflation. However, if the Fed raises the FFR this can keep inflation down because people purchase fewer things and borrow less money.
This also leads into another question; why would the Fed lower interest rates at the beginning of the Great Recession? This is a fairly simple question to answer actually. One of the basic assumptions within Economics is that a decrease in interest rates will lead to an increase in investment spending. An increase in investment spending helps businesses to create jobs and alleviate economic distress. Also, a decrease in interest rates leads to an increase in consumer spending because this would mean that interest rates for cars, homes, etc. are lower. To wrap it all up, the Fed decreased rates in 2009 in order to increase investment and consumer spending, stimulating a troubled economy.
Now, eight years later we have recovered from the Great Recession and face a different dilemma. In the United States, we average a recession every seven years and lowering interest rates is one major way we battle recessions. Again, we are eight years removed from the Great Recession; however, the current FFR is between .5% and .75%. This is concerning because we are overdue for another recession, and if one were to come soon, we would be without one of our major weapons to fight it.
This is why there has been an overwhelming desire from some for the Fed to increase interest rates aggressively this year. While most aren’t anticipating for a raise in March when the Fed meets, many do believe we will see a raise in the summer. Whatever the outcome of the Federal Reserve meeting in March, we should all hope that the Fed begins to raise the FFR soon.
– Mason Boyd