Q&A: How a key Fed interest rate affects the economy

Fed's first hike to key interest rate would have more of a psychological than practical effect

WASHINGTON — The recovery from the Great Recession has generated solid stretches of economic growth and job creation, but has failed to impress Federal Reserve policymakers enough to provide a key validation of the economy's strength — an interest rate increase.

That is poised to change as central bank officials signaled that they could raise their benchmark rate as early as this week's policymaking meeting, though analysts don't expect a move until at least September.

The last time the Fed raised the rate was in mid-2006, a year and a half before the start of the worst recession since the Great Depression.

As the economy deteriorated, Fed policymakers ratcheted the rate down from 5.25% to near zero in December 2008 in an attempt to stimulate growth. It has been there ever since.

Despite an uneven recovery, the economy is much stronger today, justifying a rate increase. But the first one would have more of a psychological than practical effect because the Fed probably will increase the rate's target level by only 0.25 percentage point, a small move.

"At the end of the day, it really is more symbolic," said Diane Swonk, chief economist at Mesirow Financial. "It's going to be an acknowledgment of the economy's strength. It's not to combat inflation. It's not to combat an overheating economy."

Fed Chairwoman Janet L. Yellen has said policymakers would decide when to raise the interest rate based on an assessment of economic data. Even after the initial increase, the rate would probably rise slowly over several years to avoid stalling the economy, she said.

The strategy is known as "lower for longer" and shows how central bank officials are planning to move deliberately to avoid slowing the economy.

"This is a Fed that's not going to do anything until it sees the whites of the eyes of a self-sustaining recovery," Swonk said.

Here are some common questions about interest rates and how the central bank manipulates them to try to help the economy:

Exactly what interest rate is the Fed looking to raise?

When people talk about the Fed raising interest rates, they are referring to the federal funds rate.

Banks are required to hold a set amount of reserves at the Fed. Those reserves are known as federal funds.

The reserves fluctuate daily. So banks that have a surplus can lend the money overnight to banks with less than the required amount of reserves. The rate at which banks make those loans is the federal funds rate.

How does the Fed control the federal funds rate?

The 12-member Federal Open Market Committee, which includes the seven members of the Fed's board of governors, votes to set a target for the federal funds rate based on economic conditions.

Normally the target is a specific interest rate. But since December 2008, the federal funds target has been a range — zero to 0.25% — because the Fed wanted to get the rate as low as possible without causing practical problems that would come with paying no interest on bank reserves.

The daily figure, known as the effective rate, has fluctuated from 0.07% to 0.22% since then.

Why does the Fed manipulate the federal funds rate?

The Fed moves the rate up or down to try to keep the economy running smoothly. Its effort is part of the mandate from Congress to enact policies that provide maximum employment, stable prices and moderate long-term interest rates.

If the economy is struggling, the federal funds rate is reduced to lower bank borrowing costs in hopes of stimulating activity. If the economy is overheating, the rate is increased to make borrowing more expensive and keep inflation from rising too much.

One of the most notable rate changes came in 1980-81 when Fed policymakers raised the target as high as 20% to curb runaway inflation. Conversely, the Great Recession spurred the Fed to lower the target rate for the first time to what's known as the zero lower bound — from zero to 0.25%.

The last time the Fed raised the rate was in June 2006, to 5.25%. It was the last of 17 increases during a two-year period as the Fed tried to reduce upward pressure on prices while the economy was expanding.

How does the federal funds rate affect other interest rates?

Although the federal funds rate applies only to short-term lending between banks, it affects other borrowing costs and, therefore, has become a benchmark for consumer and business loan rates.

Bank executives as well as investors also pay close attention to the Fed's views on the economy and tend to adjust their business plans accordingly.

For example, the so-called prime rate is set by commercial banks, supposedly for their best customers. It is used to determine interest rates for credit cards, car loans, small business loans and home equity lines of credit.

The Fed has no direct role in setting the prime rate, but it notes that "many banks choose to set their prime rates based partly on the target level of the federal funds rate."

Historically, the prime rate has been three percentage points higher than the federal funds rate, so when the Fed makes a change, the banks usually follow.

When the central bank raised the federal funds rate 0.25 percentage point in June 2006, many banks raised their prime rate by the same amount. And when it cut the benchmark rate 0.75 percentage point to near zero in December 2008, banks lowered their prime rate to 3.25% from 4%.

Does the federal funds rate affect mortgage rates?

The federal funds rate has less of a direct effect on mortgage rates, which are longer term and driven more by supply and demand in the mortgage market.

But the Fed's interest rate decisions and other actions can move mortgage rates.

Mortgages are often packaged into securities that are bought by investors. The Fed can influence demand in that market by purchasing those securities.

To help the housing market recover after it crashed in 2007, the Fed launched a controversial effort known as quantitative easing that involved purchasing hundreds of billions of dollars in mortgage-backed securities and Treasury bonds. That helped to bring down mortgage rates.

Also, some analysts said, long-term rates effectively reflect the way that a series of short-term interest-rate changes are going. So a number of increases in the federal funds rate could send mortgage and other longer-term rates higher.

jim.puzzanghera@latimes.com

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