Samantha Lee/Business Insider
Banks give out money all the time — but for a fee.
When we borrow and then pay back with interest, it’s how they
The cost of borrowing — interest rates — makes a big difference
on which credit card you choose, or whether you get one at all.
If your bank wants to make it more expensive to borrow, it’s not
as simple as just slapping on a new rate, as a grocer would with
milk. That’s something controlled higher up, by the Federal
Reserve, America’s central bank.
Why does the Fed care about interest rates?
In 1977, Congress gave the Federal Reserve two main
tasks: keep the prices of things Americans buy stable, and
create labor-market conditions that provide jobs for all the
people who want them.
The Fed has developed a toolkit to achieve these goals of
inflation and maximum employment. But interest-rate changes make
the most headlines, perhaps because they have a swift effect on
how much we pay for credit cards and other short-term loans.
From Washington, the Fed adjusts interest rates to spur all sorts
of other changes in the economy. If it wants to encourage
consumers to borrow so spending can increase, which should help
the economy, it cuts rates and makes borrowing cheap.
When people are spending like crazy, it raises rates so that
an extra credit card suddenly doesn’t seem very desirable.
Most of the time, the Fed adjusts rates to respond to inflation —
the increase in prices that happens when people borrow so much
that they have much more to spend than what’s available to buy.
However, what the Fed is doing right now is a bit unusual.
”This is the first tightening cycle where they’ve been concerned
about inflation being too low,” Alan Levenson, the chief
economist at T. Rowe Price, told Business Insider.
The Fed’s preferred measure of inflation last touched its 2%
target in 2012. So the Fed can’t exactly argue that it is raising
rates to fight inflation, although it expects prices to rise.
So how do rates go up or down?
Banks don’t lend only to consumers — they lend to each other as
That’s because at the end of every day, they need to have a
certain amount of capital in their reserves. As we spend money,
that balance fluctuates, so a bank may need to borrow overnight
to meet the minimum capital requirement.
And just like they charge you for a loan, they charge each other.
The Fed tries to influence that charge, called the federal
funds rate, and it’s what they’re targeting when they raise or
cut rates. When the fed funds rate rises, banks also hike the
rates they charge consumers, so borrowing costs increase across
Floor and ceiling
After the Great Recession, the Fed bought an unprecedented amount
in Treasurys to inject cash into banks’ accounts. There’s now
over $2 trillion in excess reserves parked at the Fed; there was
less than $500 billion in 2008.
It figured that one way to pare down these Treasurys was to
lend some to money-market mutual funds and other dealers. It does
this in transactions known as reverse repurchase operations that
basically involve selling the Treasurys and agreeing to buy them
back the next day.
The Fed sets a lower “floor” rate on these so-called repos.
Then it sets a higher rate that controls how much it pays banks
to hold their cash, known as interest on excess reserves, or
IOER. This acts as a ceiling, since banks won’t want to lend to
each other at a rate lower than what the Fed is paying them — at
least in theory.
In December, the Fed set the repo rate at 0.50% and the IOER rate
at 0.75%. With the 25 basis-point increase expected on Wednesday,
the new “floor” repo rate becomes 0.75% and the ceiling 1.00%.
The effective fed funds rate, which is what banks
use to lend to each other, will then float somewhere between
0.75% and 1.00%.
When the Fed raises rates, banks are less incentivized to lend,
since they are earning more to park their cash in reserves.
That reduces the supply of money and raises its price.
But I’m not a bank
After the Fed successfully lifts the fed funds rate, the
baton is passed to banks.
Banks first raise the rate they charge their most creditworthy
clients, like large corporations. This is known as the prime
rate. Usually, banks announce this hike a few days after the
Things like mortgages and credit card rates are then benchmarked
off the prime rate.
“The effect of a rate hike is going to be felt most
immediately on credit cards and home equity lines of credit,
where the quarter-point rate hike will show up typically within
60 days,” Greg McBride, the chief financial analyst at
Bankrate.com, told Business Insider.
Here’s how the Fed raises interest rates – Business Insider