Actually, the Fed does not raise rates. It does not just order lenders to charge higher interest rates and and make your credit card and mortgage payments go up. It uses “monetary policy” to keep the US economy stable. When the economy grows too fast, inflation occurs, and that destabilizes markets and encourages people to spend and not save. Inflation happens when you have a finite amount of resources everyone wants, for example, oil. If the incomes, bank accounts and appetites of all the oil consumers increase, but there is still the same amount of oil available, its price will go up. And if that happens quickly, it can trigger oil hoarding, runs on banks as consumers empty their checkbooks to buy oil before it gets even more expensive…instability in an economy is a bad thing, and that’s what central banks try to avert.
To control inflation, then, the Fed finds ways to restrict the amount of money available.
What DOES the Fed Do?
Here’s how the Fed might lower the supply of money and keep the oil supply affordable.
- It can increase the required reserves, money that banks must keep on hand for depositors. This restricts amounts that are available for loans to consumers or companies. The reserve funds are lodged with the Federal Reserve (now you know how it gets its name). When banks need short-term cash to cover their operating needs, the Fed allows them to lend these reserves to loan each other at what’s called the “Federal Funds Rate.”
- By raising the Federal Funds Rate, the Fed indirectly increases interest rates, because when lenders have to pay more for money, they have to charge borrowers more.. More expensive money reduces borrowing, which slows down purchasing, which releases inflationary pressure.
How Does That Affect Mortgage Rates?
Most experts would argue, “Not much.” The chart below shows both the Federal Funds rate over time and the 30-year mortgage rate average from Freddie Mac’s weekly survey. There doesn’t appear to be a whole lot of correlation between the two.