Why Did The Fed Raise Interest Rates?
Two major missions of the Federal Reserve are to try to ensure moderate long-term interest rates and to stablize prices. If you’ve read the news lately, inflation is a hot button topic. There are several reasons for the rapid pace of price increases the economy is experiencing right now, but the only thing the Fed can control is the federal funds rate. Let’s take a brief look at how we got here.
What we have going on across the globe is really the confluence of three things: Supply chain disruption related to economic shutdowns caused by the pandemic, more money in the economy due to COVID-19-related stimulus, and sanctions and embargoes on Russian oil because of the war in Ukraine.
When the U.S. central bank raises the federal funds rate, it’s doing so in an attempt to curb inflation. However, since the federal funds rate is the rate at which banks borrow from each other overnight, it really impacts all interest rates across the board because every other rate a lender sets fluctuates with it. Increases of less than a percentage point can have a dramatic effect on borrowing, particularly at higher loan amounts.
When rates go up, they can do so more than once and often do. The federal funds rate has increased three times in 2022, rising 1.5% so far. This puts it in a range of 1.5% – 1.75% as of this writing.
Based on the projections and comments of the Fed governors, it’s anticipated that they could make a fed rate hike several more times this year, in increments of 0.5% or more in the short term, with small 0.25% increases later on. However, there is good reason to believe based on continued high inflation reports that the Federal Reserve will likely increase the rate by 0.75% again later in July.
The Fed must balance a desire to control inflation with the negative impacts it can have on the economy. The idea of these rate hikes is to make it more expensive for people to borrow money, which slows down spending. If demand drops, the theory goes, sellers will lower or keep a lid on prices until demand comes back.
However, the other thing low interest rates help with is business expansion. If it’s cheaper for businesses to borrow, they’ll expand and employ more people. If you raise rates too fast, you risk spending cooling more than you might want. If there is less demand for products and services, businesses tend to lay people off. This directly hurts the Fed’s other Congressional mandate of providing an environment conducive to maximum employment.
If people aren’t spending and they’re losing their jobs, this can lead directly to a recession. Although the economy tends to go in cycles, this is something every Fed chairperson wants to avoid. For this reason, while there’s theoretically no limit to how many times the Fed can raise rates, it’s a delicate balancing act.
The way the federal funds rate impacts mortgages depends on the type of mortgage you have. If you have a fixed-rate mortgage already and you’re not looking to refinance or buy a new home, your mortgage rate won’t change.
If you’re buying a home or currently refinancing with a fixed-rate mortgage, there is no direct relationship between mortgage rates and the federal funds rate. That’s because rates are set based on the yields for mortgage-backed securities (MBS) and your personal financial picture. The Fed has beenvery involved in the MBS marketat various times since the late 2000s, but the mechanism is different from the federal funds rate.
If you have an adjustable-rate mortgage (ARM), your interest rate has a much greater likelihood of being impacted by increases in the federal funds rate. The initial ratein effect for the first several years of the ARM is set based on prices in the MBS market.
However, the adjustments may be tied to a bank’sprime rateor another index that tends to move in the same direction as interest rates in the broader market. In this case, if the federal funds rate is going up, it’s a good bet that your rate is going up at the next adjustment, depending on caps in your mortgage contract.
