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What Happens When the Fed Raises Interest Rates, In One Rube Goldberg Machine

What happens when the Fed raises interest rates? As the NYTimes describes, there are 10 steps to the Fed hike:

Step 1. New Tools…

It all kicks off here. Typically, when people say “the Fed raised rates,” they’re using a form of shorthand. The Fed (or, technically, its monetary policy committee) is really raising its target for the federal funds rate, the rate at which banks lend to each other. Then the Federal Reserve Bank of New York’s trading desk buys and sells securities to try to get that rate to line up with the target. But it gets even more complicated. In the last few years, the tools the Fed uses have evolved, so it will need to try some new tricks to make sure its desired policy happens in practice.

Step 2. …Make Finance Tight…

You don’t need to worry about the details of the country’s financial plumbing to understand the key idea: When the Fed decides it’s time for higher interest rates, it does what it needs to do to make sure that the cost of borrowing money rises across the banking system. All financial institutions and banks are in the business of buying and selling money, so when the Federal Reserve carries out a rate increase, money quickly becomes more expensive for all banks and other institutions, even at those that don’t do any direct transactions with the Fed.

Step 3. …And Push Up Rates.

When banks and other financial institutions face higher costs, they pass those costs on to their customers in the form of higher short-term and long-term interest rates. In theory, short-term rates and long-term rates move together. In reality, though, they don’t always do so.

… How It Might Not Work …

When the Fed raised rates in the mid-2000s, long-term rates didn’t go up. This puzzled a lot of economists, including the Fed chairman at the time, Alan Greenspan. The culprit, according to a theory put forward by his successor, Ben Bernanke, may have been savers in countries like China. They were sitting on piles of cash and had few reliable places to park it, so they chose the safest vehicle they could find: United States government debt. Whether that analysis is correct or not, the key idea is that while the Fed has a great deal of control over interest rates in the short run, it has a good deal less in the long run.

Step 4. Higher Rates Strengthen the Dollar…

When interest rates rise, domestic assets like Treasuries and corporate bonds will become more attractive to foreign investors. After all, it’s more desirable to hold dollars if you’re receiving higher interest rates. But in order to buy these assets, the investors are going to have to trade whatever currencies they have for dollars, raising demand for the currency and causing it to appreciate.

Step 5. …And Stocks Fall (in Theory).

And the bond market isn’t the only place where the rate move can affect financial markets. For the past seven years, low rates have made bonds relatively unattractive, and the stock market comparatively more attractive. When rates go up, some of that money will tend to flow back into bonds and away from the stock market.

Step 6. Higher Rates Make It to Main Street,

When banks raise rates, it affects different consumers differently. Taking out an auto loan, carrying a balance on a credit card, or buying a house with a mortgage becomes more expensive. Those with large savings at the bank will get larger interest payments. Rate increases make life a little bit harder for borrowers and a little bit easier for savers.

… How It Might Not Work …

As we mentioned before, there is a possibility that long-term rates will not rise. This phenomenon helped cause the housing boom a decade ago and is why a rate increase today might not mean that mortgage rates go up.

Deposit rates might not rise, either. Banks have been known to be slow with raising deposit rates and fast with raising lending rates. That’s because higher deposit rates cost banks money while higher lending rates make banks money.

Step 7. …So People Buy Less Stuff…

Well, only the stuff that people use loans to buy. A car that was affordable with a 3 percent auto loan rate might be unaffordable at 4 percent, so fewer people buy one. Rising rates for auto loans, credit cards and home mortgages will convince some consumers that they might not need to buy some things after all.

Step 8. …And Companies Cut Back,

If people slow their buying, the companies making houses, cars and couches will have too many on hand. This will cause businesses to slow investment and hire fewer workers. A weaker hiring environment means workers have less power to demand raises, and higher unemployment leads to less spending.

… How It Might Not Work …

Some economists worry that rate changes might have less of an impact on employment than they used to. Over the last few decades, there has been a structural shift in America’s work force. Employment in sectors that are sensitive to changes in interest rates (like autos) is declining, while employment in sectors that are not sensitive (like health care) is growing. This may reduce the ability of the Fed to guide the economy using its monetary policy.

Step 9. …Trading a Slower Economy…

Lower spending from households and lower investment from companies mean less economic activity. It sounds like a bad side effect, but when managed correctly, it’s sort of what the Fed wants. Ideally, the Fed wants the economy to grow at a sustainable pace that won’t cause inflation above the Fed’s 2 percent target, even if that means slowing the economy a bit along the way.

Step 10. …For Less Inflation.

With less demand for their products, businesses will feel less comfortable raising prices, and workers will be in a worse position to demand pay raises. Together, that means prices will rise even more slowly than they otherwise would across the economy. In other words, higher interest rates, after all that, have translated into less inflation.

Summary

New tools make finance tight and push up rates. Higher rates strengthen the dollar and stocks fall (in theory). Higher rates make it to Main Street, so people buy less stuff and companies cut back, trading a slower economy for less inflation.

The NYTimes | The Fed Machine