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9 questions about interest rates you were too embarrassed to ask

Federal Reserve Chair Janet Yellen.
Federal Reserve Chair Janet Yellen.
Chip Somodevilla/Getty Images

At 2pm, the Federal Reserve made it official: it is raising a key interest rate for the first time since 2006. The move was widely expected, but it also remains somewhat controversial, because critics say it could hamper a still-anemic recovery.

Arguments about Fed decisions tend to get pretty deep pretty fast. What tends to get lost in the shuffle are the most fundamental and important issues: that a somewhat obscure government agency exercises enormous control over the economy by changing the price of money at regularly scheduled meetings.

Since the state of the economy ends up influencing everything from your ability to get a new job to the outcomes of presidential elections, that makes these meetings one of the most important events on the calendar. Yet they're rarely discussed outside specialist circles except by the occasional crank, leaving ordinary people in the dark.

1) What are interest rates, and why does the Fed get to control them?

An interest rate is the price lenders charge to borrowers to use their money. An interest rate of 5 percent means that someone borrowing $1,000 will have to make interest payments of $50 per year — in addition to eventually paying back the amount that was originally borrowed.

There are different interest rates for different types of lending — home mortgages, business loans, credit cards, and so forth.

But when economists talk about the Fed "raising interest rates," they're referring to a specific rate called the federal funds rate. That's the rate big banks charge one another for short-term loans.

People often talk about the Fed "setting" this interest rate, but that's not quite accurate. What happens is that the Fed announces a target for the federal funds rate and then uses its ability to create or destroy money to reach its target.

Of course, these actions don't only affect the federal funds rate. When the Fed pushes the rate up or down, it tends to push other interest rates in the same direction as the federal funds rate. So ultimately, the Fed's interest rate decision will have an impact on the rates you pay the next time you borrow money — whether it's with a mortgage, an auto loan, or a credit card purchase.

2) Why do the Fed's interest rate decisions get so much attention?

By itself, the federal funds rate isn't especially important to anyone but bankers. However, when the Fed manipulates the federal funds rate, it can have broad economic effects.

This is often described mechanically, as a question of the interest rates spurring or strangling economic activity. For example, if mortgage rates rise, it becomes harder for people to buy new houses, which can hurt employment in the construction industry. If interest rates for business loans go up, it becomes harder for companies to finance the construction of a new factory. And so forth.

That's all true, but it can also introduce confusion because causation can move in the other direction. When economic activity is robust there's a lot of demand for loans, which can pull interest rates up. And focusing too much on specific lending markets can obscure a more fundamental point about why the Fed's decisions matter: Money is an essential fuel for economic activity. Recessions happen when people spend less than they did before. Booms happen when people spend more. So all else being equal, putting more money into people's pockets is going to produce more demand for companies' products, more economic activity, and more jobs.

3) What did the Fed do at this month's meeting?

At every meeting since 2008, the Fed has decided to keep interest rates near 0 percent.

But this time, the Fed announced that it would raise its target for the federal funds rate to 0.25 percent. That's the first interest rate hike since 2006.

At the same time, it issued a statement signaling that it won't do further rate hikes too quickly, giving the economy more room to grow.

4) If low interest rates are so great, why not keep them low forever?

If low interest rates are so good for the economy, you might be wondering why they should ever be increased. The reason is that pumping more money into the economy only works up to a certain point.

During a recession, there are a lot of idle resources. People are unemployed, factories are producing below their maximum capacity, trucks and ships sit empty a lot of the time, and so forth. In that situation — the kind of situation we had in 2001 and 2009 — getting people to spend more will mobilize idle resources and boost the real output of the economy.

But during an economic boom, things look different. With few idle resources sitting around, there's no way for more consumer spending to translate to more output. If the Fed cuts rates during a boom, the result is likely to just be that prices go up — inflation — without generating much economic growth.

That's what happened in the late 1970s. The Fed kept interest rates too low for too long because it feared that higher interest rates would be economically harmful. That produced double-digit inflation that created chaos for many Americans.

The traumatic inflation of the 1970s looms large in the minds of senior Fed policymakers, most of whom are old enough to remember it firsthand. They're determined not to repeat the mistakes of their predecessors and let inflation get out of control.

5) What's the case for keeping interest rates low?

The theoretical case for raising rates to ward off inflation is strong. But the case for raising rates right now runs into a huge problem: Inflation is really low right now. It's been low since 2008, and market forecasts suggest that it will continue to be low over the next decade.

Like many countries around the world, the Fed has set an inflation goal of 2 percent. Yet over the last year, prices — as measured by the consumer price index — have increased by just 0.5 percent. That's mostly because oil prices have been falling; if you exclude volatile food and energy prices, the inflation rate is 2 percent — exactly in line with the Fed's target. Another inflation measure that's a favorite of the Fed's, called the core personal consumption expenditure index, currently stands at 1.3 percent — below the 2 percent target. Moreover, markets are projecting that the average inflation rate will be below 2 percent over the next decade.

And while the economy has been doing pretty well, there's reason to think it could be doing better. True, the unemployment rate is down to 5 percent, not too far from what economists regard as the full-employment level. But the labor force participation rate — the fraction of all adults participating in the labor force — is close to a 30-year low, suggesting that an economic boom might draw more people into the labor market. The economy has been growing at a respectable but not spectacular rate, and wages have barely been growing faster than inflation.

We don't know if keeping interest rates low will boost economic growth. But given that the inflation rate is actually below the Fed's target, it seems there's not much risk in giving it a try. If inflation shows signs of picking up, the Fed can always raise interest rates later.

6) What's the case for raising rates now?

People have made a number of arguments in favor of raising interest rates, but on some level they all boil down to the view that seven years of ultra-low rates is unnatural.

Prior to 2008, it had been many decades since the federal funds rate was zero, and a lot of people find the current interest rate environment deeply unnerving. As Vox's Matt Yglesias has written, there's a widespread view that zero percent interest rates are a kind of life-support measure for the economy. Now that the patient is recovering, people think, we should remove the breathing tube so he can get back to breathing normally.

What happens if we keep the patient on zero-percent-interest life support? As we've seen, people normally worry that low interest rates will generate high inflation. And in the first few years after the Fed slashed rates in 2008, a lot of people warned that inflation was just around the corner. But after seven years of low interest rates and low inflation, those fears have started looking a bit silly.

So today, advocates of higher rates mostly focus on bubbles. A good example is Sen. Rand Paul (R-KY), son of longtime Federal Reserve critic, gold standard advocate, and former Rep. Ron Paul (R-TX). The younger Paul co-authored an op-ed for the Wall Street Journal in September blaming low interest rate policies over the past 20 years for the stock market bubble of the late 1990s and the real estate bubble that popped in 2007.

In Paul's view, prolonged periods of low interest rates encourage people to make risky, unsustainable investments. Recessions, in his view, are a painful but necessary process that purges the economy of bad investments. When the Fed keeps rates "artificially" low, it merely prolongs the day of reckoning and allows these bubbles to get bigger than they otherwise would have gotten. Hence, because the Fed tried to cushion the 2000 stock market crash with low interest rates, we got an even bigger crash in 2008. Paul predicts we'll have a third crash — perhaps even bigger than the previous two — as a result of current Fed policies.

But this argument doesn't explain how to tell whether rates are "too low." The federal funds rate was around 5 percent in the late 1990s — that was low relative to the previous couple of decades, but it was actually higher than rates for most of the 1950s and 1960s. There's widespread agreement among monetary hawks that monetary policy should be more "normal" — i.e., not zero — but little clarity about how high rates need to be to avoid bubbles or other financial calamities.

6) Can we take a music break?

Sure thing. Listen to the classic Dire Straits song "Money for Nothing."

The song is written from the perspective of ordinary workers who envy rock stars on MTV who get "money for nothing and the chicks for free." Meanwhile, regular guys have to "install microwave ovens," do "custom kitchen deliveries," and move refrigerators and color TVs.

Obviously, monetary policy is never going to remedy this kind of inequality. Someone has to install microwave ovens and do custom kitchen deliveries, so we're never going to live in a world where everyone gets to enjoy the perks of being a rock star full-time.

But there's still a lot monetary policy can do to help those guys wrangling refrigerators and color TVs. For most of the past seven years, it was hard for regular guys (and girls) to earn a living even if they were willing to do unglamorous work like installing microwave ovens. Pumping money into the economy couldn't turn those guys into rock stars, but it did generate economic activity and make it easier for them to find jobs.

And while the labor market is a lot better than it was a few years ago, there's still room for improvement. Wages for low-end workers have been stagnant for more than a decade. If we had a few years of tight labor markets — like we had in the late 1990s — ordinary workers would have more bargaining power. Many would get raises. That's why the guys who do custom kitchen deliveries might want to root for the Fed to keep interest rates low.

7) Fed policy has been ultra-easy for years. That has to cause some kind of bad effects, doesn't it?

It's certainly true that seven years of zero percent interest rates was historically unusual. But whether recent Fed policies have been too tight, too easy, or just about right is open to debate.

It's helpful to think about a time when the Fed was in a very different situation. The late 1970s was a period of high interest rates. By the start of 1979, the federal funds rate had risen above 10 percent.

Yet inflation soared, reaching a high of 14.8 percent in March 1980, and it stayed above 10 percent until well into 1981. That's a sign that even the historically high rates of early 1979 weren't enough to keep inflation under control. With interest rates above 10 percent, monetary policy might have seemed tight, but it was actually too loose. As it turned out, the Fed had to let rates go as high as 19 percent in 1981 in order to get inflation under control.

Interest rates were high because the market was factoring high expected inflation into interest rates. If you lend money at 10 percent but the inflation rate is 12 percent, you're actually losing money! So the "natural" interest rate — the rate that struck the best balance between inflation and recession — was abnormally high.

Today we're in the opposite situation. Inflation expectations are low. The US population and economy are growing slowly, which limits demand for credit. And that means the natural rate of interest may be a lot lower than it was three or four decades ago.

The US isn't alone here. Interest rates are low across the developed world. Japan has had short-term interest rates near zero for two decades. The eurozone, the United Kingdom, Canada, and Australia all have interest rates at their lowest levels in decades.

And the experience of the eurozone suggests this isn't really the fault of central banks. As economist Scott Sumner has pointed out, the European Central Bank tried raising rates in 2011, believing the worst of the recession was over. The result was a double-dip recession that quickly forced the ECB to bring rates back down.

The US economy is now stronger than the Eurozone was in 2011, so this week's rate hike probably won't trigger a recession. But the low rates of the past few years aren't really the doing of central banks. Central banks are just reacting to market signals — cutting rates when unemployment rises, raising them when inflation becomes a problem — and the result has been historically low interest rates.

8) Is there a better way to do monetary policy than manipulating interest rates?

The Fed and other central banks have been setting interest rate targets for so long that a lot of people think of monetary policy and interest rate changes as synonymous. But there's actually no law requiring the Fed to do monetary policy this way. Fundamentally, the Fed conducts monetary policy by creating money and buying stuff with it. There's no reason the amount of money they create needs to be determined by an interest rate target.

One example of this was between 2008 and 2014, when the Fed engaged in a technique called quantitative easing. The federal funds rate had already reached zero, so the Fed couldn't drive it any lower. But the Fed still wanted to do more to support an economy that was in a major recession. So the Fed just announced that it was going to create a certain amount of money every month. It worked fine, and many economists believe it helped speed the economic recovery over the last seven years.

Still, quantitative easing has two big disadvantages. One is that it's pretty ad hoc. It's hard for the Fed to know how much money to print or how long the money-printing process should go on.

The even larger problem, though, is political. Because the Fed's "normal" monetary policy approach is to target interest rates, quantitative easing generally gets labeled "unconventional" or "extraordinary" — even though the actual mechanism of printing money and buying government securities is very similar in both cases. This tends to create a political backlash and make the Fed reluctant to use QE as forcefully as might be appropriate.

The Fed twice halted its bond-buying programs — once in 2010 and again in 2012 — before bad economic news forced them to restart them. This tentative approach may have hampered the economic recovery.

A different approach would be to stop targeting interest rates and instead directly target a variable the public cares about, such as the growth of total spending in the economy. In an approach known as nominal GDP targeting, the Fed would commit to printing enough money so that total spending in the economy grows at 5 percent per year.

9) I skipped to the end. Can you just tell me how the Fed's rate hike will affect me?

The Fed's interest rate decisions might seem pretty remote, but they can actually have a big impact on every American. When the Fed keeps interest rates low, it means there will be more money flowing through the economy, which is likely to mean more economic activity and more jobs.

By itself, this week's 0.25 percent rate hike isn't going to have a big impact on the US economy. But it's significant because it could signal the start of a sequence of interest rate hikes that could have significant effects on the economy. The Fed has tried to mollify those fears with a statement signaling that it won't raise rates too quickly in the future.

Of course, if the Fed keeps rates low for too long, the economy could overheat, producing inflation. But right now there just isn't much evidence that the economy is overheating. The inflation rate is well below the Fed's 2 percent target, and the economy has been adding jobs more slowly than in previous economic expansions.

So if you'd like to see the economy grow more quickly, unemployment fall, and wages rise, then you might see this week's decision to raise rates as premature. In contrast, if you're most worried about inflation, you should be happy that the Fed has started to raise rates — just to be on the safe side.