Consumers with variable-rate credit cards and home equity lines of credit will pay higher interest rates as a result of the Federal Reserve’s decision to raise the target for the federal funds rate.
Rates on auto loans, home equity loans and certificates of deposit have been rising in anticipation of the Fed’s rate increase, and they are likely to rise more. Mortgage rates have been rising since March and already anticipate that today’s Fed rate increase will be just the first in a series.
The Fed’s Open Market Committee raised its target for the federal funds rate by one-quarter of a percentage point, to 1.25 percent. The prime rate will rise to 4.25 percent.
This is the first Fed rate increase since May 2000, and comes after 13 consecutive rate cuts that reduced the federal funds rate from 6.5 percent at the end of 2000 to 1 percent in June 2003.
In its statement, the Fed said that rates are still low, or “accommodative,” and that it’s not overly worried about inflation. “The evidence accumulated over the intermeeting period indicates that output is continuing to expand at a solid pace and labor market conditions have improved,” the statement read. “Although incoming inflation data are somewhat elevated, a portion of the increase in recent months appears to have been due to transitory factors.”
The federal funds rate is what banks charge one another for overnight loans to cover reserves. The prime rate moves in lock step with it. Banks charge the prime rate to their best customers, and some types of consumer loans — mainly variable-rate credit cards, home equity lines of credit and auto loans — move up and down with the prime rate.
This increase was not a surprise. It was telegraphed at the last rate-setting meeting, on May 4, when the Fed said in its statement that it could raise rates gradually — or, in Fedspeak, “at a pace that is likely to be measured.”
At 1.25 percent, the federal funds rate is still below most measures of inflation, which means that the “real” interest rate — the federal funds rate minus the inflation rate — is below zero. For example, the consumer price index was up 3.1 percent in the 12 months that ended May 31. Most observers expect the Fed to raise rates several times the rest of this year to move the real federal funds rate into positive territory and ward off inflation.
It’s about time, says Eric Leeper, associate professor of economics at Indiana University. He hoped, but didn’t necessarily expect, the Fed to raise the federal funds rate by half a percentage point instead of a quarter-point.
“It’s been too long since they raised it,” Leeper says. “I have concerns about inflation, and keeping the real interest rate negative is not good policy, in my view, because it encourages people to borrow a huge amount and they don’t necessarily make productive investments.”
Lynn Reaser, economist for Banc of America Capital Management, says that, “given their assessment of the economy and what they’ve prepared the markets for,” a quarter-point increase “probably is appropriate.”
The Fed’s rate-setting committee is scheduled to meet again Aug. 10, Sept. 21, Nov. 10 and Dec. 14, and Reaser wouldn’t be surprised if the Fed skipped a rate increase at one of those meetings if inflation is subdued.