Federal Reserve hikes fed funds and discount rates a quarter point

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And the Fed says: “Raise ’em!”

With economists as well as members of the
Federal Reserve Board unusually divided on whether the Fed should boost interest rates, the outcome of a Nov. 16 policy-setting meeting was anyone’s call.

It turns out Alan Greenspan and Co. wanted a slight rate hike after all. With its third rate hike since June, the Federal Open Market Committee has effectively undone its three rapid-fire rate cuts of last fall. Those cuts were put in place to make sure a Russian debt default and other economic crises abroad didn’t derail this country’s economic expansion.

Both the federal funds rate and the federal discount rate will increase by 25 basis points. The federal funds rate will climb to 5.50 percent from 5.25 percent as a result of the move, while the federal discount rate will jump to 5 percent from 4.75 percent.

In explaining its actions, the committee revealed its concerns about the country’s extremely tight labor markets, which could cause inflation to surge. That would happen if companies have to raise wages too much in order to attract workers. Firms typically raise prices they charge for their products in order to compensate.

“The pool of available workers willing to take jobs has been drawn down further in recent months, a trend that must eventually be contained if inflationary imbalances are to remain in check and economic expansion continue,” the Fed said in its

“Today’s increase in the federal funds rate, together with the policy actions in June and August and the firming of conditions more generally in U.S. financial markets over the course of the year, should markedly diminish the risk of inflation going forward.”

The Fed also announced a neutral “bias” toward interest rates for now. That means the agency doesn’t see a need to raise or lower rates in the immediate future.

Since it’s unlikely that the Fed would consider raising rates at its Dec. 21 meeting amid the inevitable Y2K hoopla, it looks like rates may hold steady into the next millennium. The first policy-setting meeting in 2000 is in early February.

Understanding the news

The Fed increase will quickly show up in the rates for home equity lines of credit, car loans, savings accounts and credit cards. How quickly depends on the product, with rates ratcheting up within days for some (such as variable-rate credit cards) and within weeks for others (such as car loans).

It’s hard to say what mortgage rates will do. Typically mortgage rates rise in anticipation of the Fed’s move to raise rates. But that hasn’t happened this time around because market watchers have been split on what the Fed would do. In October, mortgage rates were on the way up as economic data seemed to point to a potential Fed rate hike. In November, rates have swung back down again as other economic reports seemed to suggest that the Fed would hold steady. Whatever shift mortgage rates takes in the coming weeks, it looks to be slight.

The Federal Reserve can influence the economy by changing the discount rate or the funds rate. Although those rates are very different, a change in either has the same effect: Increases slow the economy and prevent inflation; decreases spur economic growth.

Either way, it affects your budget.

Changes in the discount rate — the rate at which the Fed lends to banks — generally have been infrequent. From 1980 through 1990, for example, there were only 29 rate changes.

However, the moves tend to come in flurries. The Fed cut the discount rate seven times in a period of economic sluggishness from December 1990 to July 1992 — from 7 percent ultimately to 3 percent. From May 1994 to February 1995, when the Fed was concerned about the threat of inflation, it raised the discount rate four times — from 3 percent to 5.25 percent. The last time the discount rate changed was in August, when the Fed upped it by 25 basis points to 4.75 percent from 4.5 percent. Prior to that August hike, the discount rate had remained steady since last November.

How the funds rate works

The funds rate works differently. Banks do not earn any interest on the money they are required to have on deposit with the Federal Reserve. When reserves climb above the minimums required, banks gladly loan out that excess to other banks that need to add money to their reserves. The lending banks charge interest for this service. The rate of interest they charge is known as the “federal funds rate” or funds rate.

This rate jumps around all the time. The Federal Reserve sets the base or benchmark rate that banks charge. If Fed policies cause this rate to increase, the cost is passed on to the end user — the customer. The last time the Fed jumped in and changed the rate was in June, when the Fed raised the rate to 5 percent in order to slow the economy a bit.

Because the funds rate is the rate charged between two banks, it is also subject to market conditions. If there is a lot of demand for funds, banks can charge a higher rate. This negotiation goes on all day long, making the funds rate one of the most volatile national rates.

Direction is critical

When a Fed change is announced, the direction (up or down) of the change is critical. Increases in the discount rate generally reflect the Federal Reserve’s concern about inflationary pressures, while decreases often reflect a concern about economic weakness.

How does this affect you? Think of the bank as a wholesaler. If it costs your bank more to borrow, that cost is passed on to you. If the rate drops, those savings are also passed along.

This is most frequently done in the form of the bank’s prime rate. The prime rate is the rate charged by a bank to its “best,” or prime, customers. It is often used as an index, or a base rate, for home equity loans, home equity lines of credit and credit cards. Therefore, when the prime rate changes, the rate you are charged for those loans will adjust accordingly. If your rate goes up, so will your payments. It also has a positive effect in that banks pay you more for your deposits.

What to expect from an increase

Now, without delving too deeply into monetary policy, let’s look at what you need to know as a consumer. A newspaper headline reads: “Greenspan says increase near.” Translation: The chairman of the Federal Reserve Board of Governors, Alan Greenspan, thinks, along with his fellow FOMC members, that the economy is growing too fast.

If the economy is growing fast, then inflation will set in. Inflation increases everyone’s cost of living. The Fed doesn’t want this, so the committee increases the discount rate, the funds rate or both. The banks pass the increased cost of doing business along to the ultimate users of credit — consumers.

How do consumers react? The increased cost of credit makes the monthly payment on that new refrigerator too high. As a result, they don’t buy it this month. The stores don’t sell their inventory as quickly, and they cut back on factory orders. The factory doesn’t get as many orders, so management slows the assembly lines. They don’t want to produce goods they cannot sell. Factory workers put in less overtime, or they get laid off. They don’t have as much money to spend, so they cannot buy as much. The cycle continues and the economy slows down, inflation is averted and Greenspan and his fellow board members enjoy the warm glow of knowing they have saved us from destruction.

Capital markets react

There is a secondary effect to any change, or even rumored change, in Fed policy. It affects all of the capital markets (stocks and bonds). The Fed, by making a change in the rates, is in fact making a statement about the economy. This causes all of the capital markets to shift their rates to meet the Federal Reserve’ s expectations.

Therefore, an increase in the Fed rates will cause the capital markets to increase the required rates on all types of stocks and bonds, including U.S. Treasury obligations and mortgage-backed securities made up of bundled home loans. That sends mortgage rates charged to consumers higher.

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