After seven years of keeping a key interest rate near zero percent, the Federal Reserve has voted for a rate increase. The decision signals the central bank's growing confidence in the economy.
The Fed is raising its target for the federal funds rate — the rate banks charge when they lend money to one another — from 0 percent to 0.25 percent. By itself, that modest increase isn't going to have a big impact on the American economy. But the move is significant because it's widely seen as the first step in a longer sequence of rate increases over the next couple of years.
In a statement accompanying the rate increase, the Fed tried to signal that it would not move too quickly on further rate increases. "The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation." In plain English, the Fed is worried that moving too quickly could strangle the still-fragile economic recovery.
Fed decisions have broad effects on the economy
An obscure federal agency raising an obscure interest rate might not seem like big news. But Fed decisions have broad impacts on the US economy.
What really matters here isn't the fact that a particular interest rate is going up — it's the way the Fed is going to accomplish the interest rate hike. The Fed has the power to create or destroy money at will, which allows it to make cash more scarce (pushing up the amount of money people will pay to borrow it) or more plentiful (pushing interest rates down). For the past seven years, the Fed has been flooding the market with cash in the hope that this will boost the economy. Now the Fed is starting to reverse course.
So when the Fed raises its target rate, what it's really doing is signaling that it's going to make cash scarcer across the entire economy. That is likely to push up the interest rates on other loans — mortgages, car loans, credit cards, and so forth. It's also expected to have broad economic effects, slowing the rate at which the economy grows and creates jobs.
Indeed, in a sense this is the point of the rate hike: The Fed is worried that keeping rates too low for too long will trigger inflation, or possibly another bubble like the real estate bubble of 2007 and the technology bubble of 1999. By starting to tap on the brakes now, the Fed hopes to head off an overheated economy before it happens.
The weird thing about this is that inflation is actually below the Fed's 2 percent target. It's been below target for most of the past seven years, and markets expect the rate to continue to be below target, on average, over the next decade. So arguably, the Fed is exacerbating a real problem — sluggish job and wage growth — to deal with a problem that has yet to materialize.
What the Fed says matters as much as what it does
While most of the media coverage so far has focused on whether the Fed would raise rates at this week's meeting, the more important question is what the Fed does in the future — and what it says about its plans in the statement it releases with the announcement.
When businesses, venture capitalists, and others make investment decisions, a big factor they consider is the likely rate of future economic growth. If they expect a big boom over the next couple of years, they're more likely to make investments now to capitalize on the healthy economy. And one big factor shaping the economy's future growth is the Fed's interest rate decisions.
And that means that the Fed's statements about future interest rate hikes can have a significant impact on the economy now. The Fed's relatively dovish statement — signaling that its policy "remains accommodative" — is a signal to investors that they shouldn't be too spooked by a quarter-point rate increase. The Fed might have raised rates this week, but it's not going to do further increases too quickly.