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The Fed just took away the punch bowl

Trump’s new Federal Reserve chair just increased interest rates in a sign the economy is doing well.

Federal Reserve Board Chairman Jerome Powell testifies during a Senate Banking Committee hearing on Capitol Hill on March 1, 2018.
Federal Reserve Board Chairman Jerome Powell testifies during a Senate Banking Committee hearing on Capitol Hill on March 1, 2018.
Photo by Mark Wilson/Getty Images
Emily Stewart covers business and economics for Vox and writes the newsletter The Big Squeeze, examining the ways ordinary people are being squeezed under capitalism. Before joining Vox, she worked for TheStreet.

The Federal Reserve raised interest rates on Wednesday by a quarter of a percentage point to a 1.5 to 1.75 percent range — the highest level in a decade and a signal of continuing economic strength.

Fed officials said in a statement that the “economic outlook has strengthened in recent months” and increased their growth estimate for this year to 2.7 percent from 2.5 percent, when they last put out projections in December. Officials estimate the economy will grow by 2.4 percent in 2019 and 2 percent in 2020. They also forecast lower unemployment and an increase in inflation to their target in the “coming months.”

The interest rate move was widely expected — in December 2015, the Fed raised rates for the first time since 2006, by 0.25 percentage points, and it has been slowly raising them ever since. (It slashed rates to essentially zero in 2008 in the midst of the financial crisis recession in an attempt to jump-start the economy.)

But Wednesday’s rate increase is a bit different. For one, it is new Fed Chair Jerome Powell’s first big move after taking over from Janet Yellen in February, as well as his first policy meeting and news conference.

Onlookers are eager to get any signs or signals about what the Fed might do moving forward. It was expected to increase interest rates by a quarter of a point three times this year, but there was some chatter it could raise them four times instead, given the recent economic stimulus from Congress with December’s $1.5 trillion tax cut and federal spending increases. On Wednesday, officials stuck to the three-rate-hike plan for 2018 but indicated they will increase the pace of rate increases in 2019.

“The question about what the Fed is predicting is all about its trajectory of interest rates now,” Mark Hamrick, a senior economic analyst at Bankrate.com, told me. “It’s a widely held assumption that rates will be rising; the question is how much and when.”

The Fed uses interest rates to influence employment, inflation, and the economy

To zoom out a little bit: The Federal Reserve is the central bank of the United States. One of its main responsibilities is managing interest rates and influencing the availability and cost of credit in the American economy. It sets the “federal funds rate” — the interest rate banks charge each other for overnight loans — and can adjust the rate to sway the economy.

When the Fed fears the economy might be overheating or sees inflation on the rise, it can raise interest rates to slow the whole thing down. That raises the cost of borrowing for banks and, in turn, for consumers, which eventually affects spending across the economy.

William McChesney Martin, who led the Federal Reserve for nearly two decades, famously joked that the Fed’s job is to “take away the punch bowl just as the party gets going.” To continue the metaphor, like how some bars set the clock a bit fast to get everyone out the door before closing time, the Fed’s job is to cool down the economy just as things start getting fun.

The bank has a “dual mandate,” a set of goals it is supposed to achieve: maximizing employment and stabilizing prices for goods and services. In practice, that means the Fed needs to try to keep the unemployment rate low — the idea being that if borrowing costs are low, businesses will have more money to invest and expand and ultimately hire more workers — and target an inflation rate of 2 percent, because a higher inflation rate is costlier than a lower one.

During the Great Recession, the Fed slashed interest rates to zero and kept them there for years in an effort to help boost America’s economy. The theory is that low interest rates boost both investment and consumption because it’s cheaper to borrow and therefore there’s less incentive to save.

If the Fed does raise interest rates three times this year, as expected, they would end up in the 2 to 2.25 percent range. That’s still low — prior to the financial crisis in 2006, they were at more than 5 percent. In the early 1980s, the Fed hiked rates to as much as 20 percent to fight inflation.

What the Fed’s interest rate means for you

The Fed’s interest rate hike means different things for different people — depending on where they’ve got their money parked, their future expectations, and whether they have a lot of debt.

Generally, if you’re saving money, a rate hike will help you (at least a bit). If you have debt with variable rates, or you expect to, it could hurt you (again, at least a bit). If you have stocks, you’re probably fine, as long as the Fed doesn’t do something unexpected.

Rate hikes generally modestly benefit savers, because when the Fed rate rises, rates on vehicles such as savings accounts tend to go up as well. Fed rate hikes are reflected in CDs — certificates of deposit — to some degree, and as the Fed continues to increase rates in the months and years to come, savings rates are likely to follow as well.

“As savers of all kinds, including those who are saving or retirement, look for more conservative ways of saving their money, certainly these savings accounts will become more generous with their concerns, but they won’t be lottery jackpots by any means,” Hamrick, of Bankrate.com, said.

The St. Louis Fed points out that the interest rate on one-year Treasury bonds tends to track the Fed’s rate pretty closely, while the interest rate on 10-year Treasury bonds does not. There is, however, some “co-movement.”

For people or companies with a lot of debt — or looking to take on more debt — rising interest rates can be problematic. As the Fed raises rates on banks, banks in turn increase interest rates on credit cards, car loans, small business loans, and mortgages. In other words, if you owe money, expect to pay higher interest rates on it.

Borrowing rates in a number of arenas are already fairly high. Mortgage interest rates increased for nine straight weeks this year before dropping in March. They are still at their highest level in four years. The average credit card interest rate is about 16 percent, and increasing interest rates are likely to drive that higher too.

Rates also go up for corporations, many of which have loaded up on debt since the Fed cut interest rates to zero in 2008 in the midst of a recession. An estimated $4.4 trillion is expected to come due from corporate America by 2022, and as interest rates go up, so will the amounts companies owe to pay back that money.

“Anyone who has variable-rate debt is going to see their costs rising,” Hamrick said. “A debt does come at a cost.”

Rising interest rates can also make the stock market nervous, though the Fed has been careful to keep Wall Street calm and clearly signal what sort of interest rate increases it’s planning and when. Zero and super-low interest rates have made stocks the only place for investors to make money in recent years, and the fear is that if the Fed raises interest rates, investors will start to look elsewhere. Higher rates make borrowing more expensive and slow down credit flows to companies and individuals, which could be a drag on stocks.

If the Fed gets more aggressive than anticipated about rate hikes, that could put the brakes on the economy and, in turn, spook investors. A slowed economy translates to weaker earnings growth for companies, and that translates to bad news for stocks.

The Fed’s Wednesday announcement suggested that more rate hikes than expected won’t be in store for 2018 but may be for 2019. Officials had previously forecast two rate increases in 2019 but on Wednesday penciled in three.

“The Federal Reserve’s actions are essentially a punctuation point affirming to all of us that interest rates are on the rise and expected to rise further,” Hamrick said.

Too-fast rate hikes could put Powell on a collision course with Trump

During his presidential campaign, Donald Trump often criticized the Fed, alleging it was keeping interest rates artificially low in an effort to prop up the Obama economy.

But since taking office, the blustery billionaire has taken a liking to keeping rates down. “I do like a low-interest rate policy, I must be honest with you,” Trump said in an April interview with the Wall Street Journal. The president reportedly told former Fed Chair Yellen that he considered her, like himself, a “low-interest-rate” person.

Thus far, the Fed appears to be moving with caution when it comes to interest rates, but if it starts to move aggressively, it could put itself and Powell — Trump’s Fed appointee — on a collision course with the president. The White House has championed the December tax cuts as an effort to juice the economy and has focused on boosting economic growth. If it succeeds, that’s exactly when the Fed will step in to slow things down.

Powell on Wednesday stuck to the program on interest rates, but he may have gone afoul in another arena: tariffs. When asked about the administration’s moves to implement tariffs on steel and aluminum imports at a press conference, Powell acknowledged the matter had come up in the Fed’s policy meeting and there are some concerns. “On tariffs, a number of participants in this FOMC did bring up the issue of tariffs,” he said. “If I could summarize what came out of that, it was, first, that there’s no thought that changes in trade policy should have any effect on the current outlook.”

He added that in meetings with business leaders, “trade policy has become a concern growing for the group.”