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"What happens when the federal reserve raises interest rates?" 9-27

Today we are going to answer a question based on some news you may have seen yesterday.

 The question is:

What happens when the Federal Reserve Raises Interest Rates?

Transcript

You may be reading the financial headlines today and see that yesterday the federal reserve announced that it raised interest rates by a quarter of a percent.

 What does this mean, and how does it impact you?

 

First, the federal funds rate is the interest rate that banks charge each other to borrow money overnight. The federal reserve has many ways to control this rate that we won’t get into today. But know that ultimately, the announcement yesterday of the rise in interest rates is really the Federal Reserve announcing the new rate that it wants banks to charge when lending to other banks.

Now, more importantly, how does this effect you? Ultimately, this raise in interest rates makes money more expensive for banks. In turn, they will make money more expensive for you when you borrow. That means higher interest rates on loans.

Some interest rates rise immediately. You may notice the interest rates on your credit cards rise almost immediately, and you may see rates on very short term investments like money markets and very short term bank CDs rise very soon as well.

But it is important to know that the federal reserve can only control certain interest rates, and most of that control is of just short term interest rates.

 Other interest rates, such as the interest that a 10 year treasury bond pays is set on the open market by those buying and selling treasury bonds. Consider that the buyer of a 10 year treasury bond today is not only worried about where interest rates are today, but also where they will likely be 10 years from now. That means long term interest rates are based more strongly on expected future interest rates rather than simply today’s interest rates.

And the difference can be seen by looking at the interest rates on some treasury bonds today, which actually went down. How is that possible? The Federal Reserve issued a statement that some investors took as a hint that the Federal Reserve may not raise rates as high in the near future as previously thought.

So, treasury bonds were pricing in not only today’s interest rates, but also a certain expectation for future interest rates rising. Today, the likelihood of future rates rising actually went down, and therefore interest rates on bonds went down.

So ultimately, yesterday’s rise in interest rates means that you should expect loans to be more expensive. However, the interest rates you receive on your investments, such as bonds and especially short term bonds, should also increase. This may make bonds slightly more attractive for investors, since we can expect them to pay a high interest rate

Matt Hylland