How the Fed Steers Interest Rates to Guide the Entire Economy | WSJ

Summary

The Federal Reserve is anticipated to raise interest rates multiple times in 2022 to combat high inflation, a strategy outlined by Chairman Jerome Powell. The federal funds rate, a key tool for economic management, was nearly 0% in 2020 but is now being adjusted to influence borrowing costs and corporate decisions. These rate changes aim to balance supply and demand, thereby managing inflation. While the immediate impact may be felt in loans and mortgages, the full effect on inflation could take 6 to 12 months to materialize.

Takeaways

• 📈 Inflation is at its highest rate in 40 years, prompting the Federal Reserve to consider raising interest rates multiple times in 2022.
• 🏛️ Fed Chairman Jerome Powell emphasizes the need to tighten interest rate policy to reduce inflation back to the 2% target.
• 📉 The federal funds rate was lowered to nearly 0% in 2020 to stimulate the economy during the pandemic's onset.
• 🔧 The Federal Reserve uses the federal funds rate as its primary tool to manage the economy by adjusting borrowing costs and influencing business decisions.
• 🚗 The economy is likened to a car, with the Fed as the driver, aiming to ensure steady growth without speeding or stalling.
• 🏦 The federal funds rate is the interest rate banks charge each other for overnight loans, and it's influenced by the Fed through a target range rather than direct setting.
• 💼 The Fed's adjustments to the federal funds rate are typically made in small increments, such as a quarter to half a point at a time.
• 💰 Higher interest rates can slow down the economy by increasing the cost of borrowing, which reduces demand for loans and spending.
• 🏠 The impact of interest rate hikes on inflation may be delayed, affecting consumers and businesses in the long term through changes in the housing market and other sectors.
• 💳 Consumers and businesses may immediately feel the effects of higher interest rates on loans, mortgages, and credit cards, impacting their financial decisions.

Q & A

Why is the Federal Reserve expected to raise interest rates in 2022?

The Federal Reserve is expected to raise interest rates in 2022 to combat high inflation, which is hovering around its highest rate in 40 years, and to ensure a long economic expansion.

What is the Federal Reserve's goal regarding inflation?

The Federal Reserve aims to get inflation back down to its 2% goal.

How does the Federal Reserve manage the economy?

The Federal Reserve manages the economy primarily by changing the federal funds rate, which influences a range of borrowing costs and shapes broader decisions made by companies.

What was the federal funds rate during the beginning of the pandemic in 2020?

The federal funds rate was lowered to nearly 0% in 2020 to boost the economy at the start of the pandemic.

What are the two main goals of the Federal Reserve?

The two main goals of the Federal Reserve are to ensure stable prices and low inflation, and to make sure that the labor market is strong.

How often does the Federal Reserve meet to discuss economic data?

The Federal Reserve meets every six or so weeks to discuss a range of economic data.

What is the federal funds rate and how is it determined?

The federal funds rate is the interest rate that banks charge each other to borrow money overnight. It is not directly set by the Federal Reserve but is influenced by a target range set by the Fed using other tools.

What tools does the Federal Reserve use to influence the federal funds rate?

The Federal Reserve uses interest on reserve balances and overnight reverse repurchases to set a target range for the federal funds rate.

How do the adjustments to the federal funds rate affect the broader economy?

Adjustments to the federal funds rate affect the broader economy by influencing the cost of existing loans and demand for new borrowing, which in turn affects consumer and business spending, job growth, and inflation.

What is the goal of raising interest rates in terms of inflation?

The goal of raising interest rates is to drive down demand, which can help balance supply and demand, thereby reducing inflation.

How do higher interest rates impact consumers and businesses?

Higher interest rates can lead to fewer loans being taken out by consumers and businesses, slower job growth, decreased spending, and may also encourage saving, which can help slow inflation.

How long does it typically take for a rate hike to impact inflation?

A rate hike can take some time, possibly 6 to 12 months, to make an impact on inflation as it ripples through the economy.

Outlines

00:00

📈 Managing Inflation Through Interest Rate Policy

The Federal Reserve, under Chairman Jerome Powell, is expected to raise interest rates multiple times in 2022 to combat high inflation, which is at its highest in 40 years. The central bank uses the federal funds rate as its primary tool to manage the economy. This rate was lowered to nearly 0% in 2020 to stimulate the economy during the pandemic. Adjustments to this rate influence borrowing costs, including credit card and mortgage rates, and impact broader economic decisions made by companies. The Fed meets every six weeks to review economic data and has two main goals: ensuring stable prices with low inflation and maintaining a strong labor market. The federal funds rate is the interest rate at which banks lend to each other overnight, and the Fed influences it by setting a target range using tools such as interest on reserve balances and overnight reverse repurchases. The effective federal funds rate, set by banks, falls within this target range. Small increments in rate adjustments can significantly affect the economy by influencing demand and, consequently, inflation.

05:03

💳 Immediate Impact of Rate Hikes on Consumers and Businesses

While the Federal Reserve's rate hikes may take time to significantly reduce inflation, the effects on consumers and businesses will be felt immediately. Higher interest rates lead to increased borrowing costs for loans, mortgages, and credit cards. This can affect consumer spending and business investment decisions. The goal of raising rates is to reduce demand, which in turn can help balance supply and demand, and eventually lower inflation. However, the full impact of these rate hikes on the broader economy, particularly on inflation, may take months to become apparent.

Keywords

💡Inflation

Inflation refers to the rate at which the general level of prices for goods and services is rising, and subsequently, the purchasing power of currency is falling. In the video, it is highlighted as a significant economic issue, with the Federal Reserve aiming to control it by adjusting interest rates. The script mentions that inflation is currently at its highest rate in 40 years, indicating the urgency for the Fed's intervention.

💡Federal Reserve

The Federal Reserve, often referred to as 'the Fed,' is the central banking system of the United States. It plays a crucial role in the economy by implementing monetary policy, including interest rate adjustments. In the context of the video, the Fed is expected to raise interest rates to combat inflation, as stated by Fed chairman Jerome Powell.

💡Interest Rates

Interest rates are the cost of borrowing money and the return on investment. They are a key tool used by central banks like the Federal Reserve to manage economic activity. The video explains that the Fed is expected to raise interest rates to control inflation, which would make borrowing more expensive and theoretically reduce the money supply and demand in the economy.

💡Federal Funds Rate

The federal funds rate is the interest rate at which depository institutions (banks) lend balances to other depository institutions overnight. It is a critical tool used by the Federal Reserve to influence economic activity. The video script explains that adjustments to this rate can influence a range of borrowing costs, from credit cards to mortgage rates, and shape broader economic decisions.

💡Monetary Policy

Monetary policy refers to the actions of a central bank, such as the Federal Reserve, intended to influence economic factors like inflation and growth. In the video, the Fed's monetary policy involves tightening interest rates to control inflation, moving away from highly stimulative settings to stabilize prices.

💡Economic Expansion

Economic expansion is a period of increasing economic activity, often characterized by growth in real output and income. The video mentions the need for a long economic expansion, which the Fed aims to ensure by managing inflation and maintaining a strong labor market through its monetary policy.

💡Supply and Demand

Supply and demand is an economic model of price determination in a market. It is mentioned in the video as the fundamental driver of inflation. When demand outstrips supply, prices rise, leading to inflation. The Fed aims to balance supply and demand by influencing demand through interest rate adjustments.

💡Loan

A loan is a type of debt provided by a lender to a borrower with the expectation that it will be repaid with interest. In the video, the cost of loans is directly affected by changes in the federal funds rate. As the Fed raises interest rates, borrowing becomes more expensive, which can reduce the demand for loans and subsequently help control inflation.

💡Mortgage Rates

Mortgage rates are the interest rates charged on loans for purchasing real estate. The video script explains that these rates are influenced by the federal funds rate. When the Fed raises interest rates, mortgage rates tend to rise as well, which can affect the housing market and consumer spending.

💡Credit Cards

Credit cards are a type of revolving loan where the card issuer provides a line of credit up to a certain limit. The video mentions that credit card interest rates are also influenced by the federal funds rate. As the Fed raises rates, credit card borrowing becomes more expensive, which can discourage consumer spending and help control inflation.

💡Economic Data

Economic data refers to information on economic indicators that are used to understand and analyze the state of an economy. The video script notes that the Fed meets regularly to review a range of economic data to make decisions about interest rates. This data helps the Fed assess economic conditions and determine the appropriate monetary policy actions.

Highlights

Inflation is at its highest rate in 40 years, prompting the Federal Reserve to consider raising interest rates multiple times in 2022.

Fed Chairman Jerome Powell emphasizes the need to tighten interest rate policy to reduce inflation back to the 2% goal.

The federal funds rate is the central bank's primary tool for managing the economy, influenced by economic data reviewed every six weeks.

The rate was lowered to nearly 0% in 2020 to stimulate the economy at the pandemic's onset.

Adjustments to the federal funds rate affect borrowing costs, including credit card rates and mortgage rates.

The federal funds rate also influences broader corporate decisions such as hiring and pricing strategies.

The Fed uses the federal funds rate to guide the economy, aiming for stable prices and a strong labor market.

Economically, the Fed acts as a driver, adjusting the pace by pushing on the gas or pressing the brake as needed.

The federal funds rate is the interest rate banks charge each other for overnight loans, indirectly set by the Fed.

The Fed influences the federal funds rate through a target range set by controlling rates as a bank for banks.

The effective federal funds rate is guided to stay within the target range set by the Fed's upper and lower limits.

The Fed's rate increases for 2022 are expected to be modest, changing by about a quarter to half of a point at a time.

Higher rates for banks lead to increased charges for customers, affecting the demand for loans and the economy's pace.

The Fed's goal in raising rates is to reduce demand and balance supply and demand to combat inflation.

Low rates encourage borrowing and spending, potentially leading to higher prices and job creation.

Conversely, higher rates discourage borrowing, slow job growth, and decrease spending, helping to stabilize inflation.

While interest rates can effectively reduce inflation, the impact may take time to be felt across various markets.

Consumers and businesses may immediately feel the effects of higher interest rates on loans, mortgages, and credit cards.

Transcripts

- [Narrator] With inflation hovering around

its highest rate in 40 years,

the Federal Reserve is expected to raise interest rates

several times in 2022.

This is Fed chairman Jerome Powell

on what will be needed to ensure a long economic expansion.

- That's gonna require the Fed

to tighten interest rate policy

and do our part in getting inflation back down

to our 2% goal.

- [Narrator] The way the central bank does this

is by changing the federal funds rate,

its main tool for managing the economy.

You can see on this chart that the rate was lowered

to nearly 0% in 2020 to boost the economy

at the beginning of the pandemic.

- There is an important job for us to move away

from these very highly simulative monetary policy settings.

- [Narrator] Adjustments to the federal funds rate

influence a range of borrowing costs,

from how much you own your credit card to mortgage rates.

They also shape broader decisions made by companies,

like how many people to hire or whether to raise prices.

Here's how the federal funds rate works

and how just one rate can guide the entire economy.

- The Fed meets every six or so weeks,

and they're looking at a range of economic data

at those meetings,

but they have two main goals.

One is to ensure stable prices and low inflation.

And the other is to make sure

that the layer market is strong.

- [Narrator] Nick Timiraos covers how the fed guides

the economy through crises.

He says, you can think of the economy

as a car and the fed as the driver.

- They wanna make sure

that the economy's not growing too slow.

And when it is, they'll push on the gas

but they also wanna make sure that it's not going too fast.

And so they'll slow the economy down

by pressing on the break.

- [Narrator] This is where the federal funds rate comes in.

- When you hear on the news

about the fed raising interest rates

or cutting interest rates,

what they're actually deciding to do

is to raise or to lower the federal funds rate.

- [Narrator] This is the interest rate

that banks charge each other to borrow money overnight,

but there's a catch.

The federal funds rate

isn't directly set by the federal reserve.

So in order to influence it,

the fed uses a couple of other tools to set a target range.

These tools are rates that the fed controls in its role

as a bank for banks.

Here's the target range that was in place during 2021.

The federal reserve sets an upper limit and a lower limit

with the goal of keeping the effective federal funds rate

somewhere in between.

The upper limit is determined

by interest on reserve balances.

This is the rate of interest a bank gets on deposits

known as reserves that it keeps at the federal reserve.

The lower limit is determined

by overnight reverse repurchases.

These are securities like treasury bills,

but the federal reserve lends to banks usually for a day

while paying interest.

On this chart, you can see where the fed

has set the target range between the two yellow lines,

the blue line, which is the effective federal funds rate

set by banks sits between the upper and lower limits

as the target range changes

the effective rate goes up or down with it

- So far they've had very successful control

over guiding the federal funds rate

and guiding all short-term money market rates

to where they generally are trying to move them.

- [Narrator] The fed makes these adjustments

in fairly small increments.

Its rate increases for 2022 are expected to only change

by about a quarter to half of a point at a time.

So how can these tiny adjustments for banks

help cool down the entire economy?

It all has to do with how those rates

ripple through the system.

As banks are charged more to borrow,

they'll in turn charge their customers more,

affecting the cost of existing loans

and demand for new borrowing.

The goal of raising these rates is to drive down demand.

- Inflation results when supply and demand are outta whack.

The fed can't do anything to increase the supply of oil

or to increase the number of houses for sale.

The supply side is something out of their reach,

but they can bring supply and demand by reducing demand.

- [Narrator] Here's how rates can influence demand

and inflation.

When rates are low, more people in businesses

are likely to take out loans.

Higher demand for goods and services,

as well as lower rates allows employers

to open more positions to meet demand

and raise wages to appeal to potential employees.

Consumers then turn around

and spend those wages on goods and services,

which in turn can lead to more jobs and higher prices.

The opposite happens when rates are higher.

Fewer people and businesses take out loans,

job growth slows, and spending decreases.

Higher interest rates may also make it more appealing

to save.

Inflation slows as supply and demand balance out.

While interest rates can be effective

in bringing inflation down,

a rate hike could take some time to make an impact.

- Think about your own life

as you go through making different decisions

about whether to buy a house and how big of a house to buy.

It may take a while for this

to ripple through the housing market, for example,

but in 6 or 12 months, we could begin to see, you know,

less demand if interest rates are high enough

to slow interested consumers.

- [Narrator] But while inflation may take time to come down,

consumers and businesses will likely feel the impact

of higher interest rates on loans, mortgages,

and credit cards right away.