Questions and Answers   

The Federal Reserve recently enacted the first interest rate hikes since 2000 by increasing its target for the federal funds rate from 1 percent to 1.25 percent in June and to 1.5 percent in August. The Fed’s federal funds rate target had stood at 6.5 percent at the end of 2000 before a series of interest rate declines that began in January 2001 finally brought the fed funds rate to just 1 percent during the summer of 2003. Perhaps the two most obvious questions to consider here are: 1) Why has the Fed started to raise rates?, and 2) How will higher rates impact individuals and the economy?

First, the Fed has embarked on its current rate-tightening cycle primarily because of an improved economy and signs of higher inflation. Since the fall of 2003, the national economy has clearly been improving. Yes, some recent reports on job growth have been below expectations, but most economists – including Alan Greenspan -- anticipate better job growth and continued economic growth. The rate of growth of the U.S. economy over the last year is considered consistent with marginally higher inflation. As such, the Fed has started to slowly raise interest rates in an attempt to prevent unsustainably high economic growth and unacceptably high rates of inflation. Assuming there are no major disruptions to the current economic expansion, the Fed will likely continue to slowly raise rates until the federal funds rate is roughly 3.5 percent, perhaps taking the next 12 to 18 months, depending on the strength of the economy.

In terms of the impact of higher rates, the effects over the next year or so are likely to be relatively subtle. You may have noticed already that not all interest rates have responded identically to the Fed’s recent rate hikes. For example, 30-year conventional mortgage rates had averaged just over 6.25 percent in May and June, but have since fallen back to under 6 percent (as of mid-August).

Clearly, there are more forces at work in determining the level of interest rates than just what the Fed chooses to do. Almost every interest rate in the economy is determined by the market forces of demand and supply. In recent years the difference between long-term and short-term rates has been unusually high. This suggests that the Fed has room to engineer higher short-term rates without a proportional increase in longer-term rates. This means that while the Fed slowly tightens the money supply and credit availability, only gradual increases will be seen in longer-term interest rates.

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