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What the Fed’s interest rate liftoff means for the economy: Yahoo U

Yahoo Finance's Brian Cheung explains how the Federal Reserve raising interest rates affects the U.S. economy on this week's Yahoo U.

Video Transcript

BRIAN CHEUNG: Well, obviously the big news is that the Federal Reserve yesterday moved to raise interest rates for the first time since the beginning of the pandemic and actually for the first time since 2018. But obviously, the big looming question for those wondering is, what does 25 basis points-- as the smart people call it, it's 0.25%-- actually do? Well, for a refresher, it's time for our Yahoo U.

And one primary way that the Fed conducts monetary policy is, of course, by setting short-term interest rates. So during times of economic malaise or downturns, right, the Federal Reserve will lower interest rates to spur more borrowing and lending. So in theory, this is going to stimulate the economy as low deposit rates at your bank, maybe encourage you to take the money out of the bank, and then go and spend it. You could do that in the form of getting a home loan or maybe spending a little bit more on your credit card. All of these things are going to be a lot easier and cheaper because interest rates on those products will also be lower.

Now all of this, lowering interest rates, happened during the financial crisis. It happened during the pandemic, which the Fed responded to, again, by lowering interest rates to the floor, basically near zero. Now that might help, but overdoing it can also lead to this, which is inflation, which we know now. Keeping interest rates at super low levels can have the impact in some cases of overstimulating demand, which might be part of the reason for why the pace of price increases has accelerated so much. And this is important within the context of the Fed because they feel that prices are stable at an annual inflation rate of about 2%. So, obviously, what we're seeing right now is well above that Fed target.

So in a case like this, what does the Fed do? Well, they turn to the reverse, which is raising interest rates. This, in theory, would pull back on economic activity. So higher deposit rates might encourage you to leave money at your bank, and then borrowing costs will make it more expensive to get a car loan, or take out a mortgage, or to spend more money your credit card, or to take out a business loan, et cetera, et cetera.

Now, of course, the natural question here is, how does the Fed actually raise interest rates? Does it just use a magic wand to do that? Well, that's where the name the central bank comes into focus here. The Fed is the banker's bank. And in the same way that we leave money at your bank or at your credit union, the Fed has large US banks parking money overnight with them. So just like your deposit rates, the Fed will pay some amount to keep the money there. And basically, up until yesterday's announcement, that rate was about 15 basis points, or 0.15%.

And that matters because that becomes the benchmark for how banks price their products, right? So again, after yesterday's announcement, the Fed said that they're going to bump up the rate that they pay by 25 basis points. So now, instead of 0.15%, it's 0.4%. So what will the banks do? They're going to turn around and they're going to increase the rate that they pay to customers for their deposits, people like me, right? So they'll increase the rate that I have in my consumer deposits to X, which would be, let's say, 0.4% as well.

Now they're also going to increase the rate that they charge customers when they take loans out. So again, instead of 0.15%, it's going to be 0.4%, let's say. Now, of course, this is a very oversimplified way of looking at it. People have never seen a sub 1% mortgage, so you're going to know that loans of longer duration, they're going to have different benchmark interest rates. And banks also price in risk and other premiums. So all of this is really more of a floor, but you get the idea of how all of this works.

And either way, the point here is that the Fed uses the rate that it pays banks to nudge economic activity. And the announcement yesterday that they're going to be nudging up interest rates to, boop, just that little bit right there, means that the Fed is now targeting interest rates between the range of about 0.25% to 0.5%. Again, that 0.4% that they're paying out is right in the middle.

But look, this is not going to be enough to tamp down inflation, right? That little blip is certainly just the beginning of all of that. That means future Fed rate hikes are going to be needed. And in fact, Fed forecasts suggest that the central bank is going to have to raise interest rates at least seven more times just to get short-term rates to a level that would be restrictive to the economy.