How a Rate Change Affects You and the Economy

When the Federal Reserve Board tinkers with interest rates, people sit up and take note. Here's why.

June 30, 2004

Why is so much attention paid to the arcane short-term loan rates charged to and by banks? Because these rates reverberate throughout the economy. Here we look at the ripple effect of a Fed rate hike -- but remember that the same is true in reverse when rates are lowered.

When the Fed raises rates, it's usually to fend off inflation and to stop the economy from growing too much too quickly and "overheating." When it lowers rates, it's usually a sign that the economy is losing steam, or stagnating, and consumers need an incentive to spend -- lower rates on mortgages, car loans and even credit cards keep the money flowing.

Below is a brief explanation of how a Fed hike works its way through the economy.

Fed raises rates: The Federal Reserve's Open Market Committee (FOMC) votes to raise rates. It does this by increasing either the federal funds rate or the discount rate, or both.

The federal funds rate -- what banks charge each other for overnight loans -- is not directly under the Fed's control, but it's strongly influenced by the Fed.

Banks are required by law to maintain a specific ratio of reserves to deposits. These reserve amounts can change daily, depending on the number and amounts of loans going out, and deposits and loan repayments coming back in. To give the banks the flexibility they need, the Federal Reserve system allows banks to borrow reserves from the Fed and from each other.

The Fed can increase the funds rate by making the overall pool of reserve dollars less available. The decreased supply increases bank competition for the money and pushes the rate higher. The higher costs eventually get passed along to individual and corporate borrowers, but we'll get to that in a minute.

The discount rate is the interest charged when banks borrow overnight loans directly from the Federal Reserve. This rate is under the control of the Fed and does not fluctuate with the market. The discount rate provides a base for interest rates and is usually the lowest rate.

Banks raise rates: In response to a Fed hike, banks raise their prime rates, the rate banks charge their best customers. The prime rate is tied to some consumer loans, including home-equity loans and some car loans. Credit card holders can expect to see prime-based interest rates edge up, too.

You shop less: Spending more to pay off your credit cards, car loan and home-equity line decreases your monthly cash flow and gives you less money to spend elsewhere.

Businesses are less likely to expand: Companies also pay more for new loans or on existing debts. Fewer sales from decreased consumer spending can contribute to businesses tightening their belts. There's likely to be less capital spending, and fewer new jobs can be created. Not only can this contribute unemployment, but it can also weaken the demand for labor, which in turn can slow economic growth.

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