Last week the Federal Reserve changed its interest rate policy. What did the Fed do, and why?
The Federal Reserve’s press release from Sept. 18 said it would “lower the target range for the federal funds rate by 1/2 percentage point to 4-3/4 to 5 percent.” The federal funds rate is the shortest of short-term interest rates, the rate banks charge each other for overnight loans. Lend the money in the evening, get repaid with interest the next morning. Changes in this short-term rate influence the longer-term rates that banks charge for business, consumer and mortgage loans.
The Fed influences the federal funds rate with another rate, called interest on reserve balances. Reserves are deposits that banks haven’t loaned. Banks earn the IORB rate on reserves that they deposit with the Fed.
In March 2022 the IORB rate was a very low 0.15 percent. That month the Fed started raising the rate to battle inflation. They raised it all the way to 5.4 percent by August 2023. Banks started keeping more reserves with the Fed. Why make a risky business or mortgage loan when you could earn a good return at the Fed, risk-free? Lending to businesses and households decreased. Business and mortgage interest rates increased. And so did the federal funds rate.
The Fed started to increase interest rates when it realized that the rise of inflation was not looking temporary. The consumer price index had risen 8.5 percent in the 12 months to March 2022, way above the Fed’s 2 percent target. Raising the IORB rate reduced borrowing and spending. When people spend less, businesses have fewer opportunities to raise prices.
The increase in the rate was rapid, more than 5 points in a year-and-a-half. Perhaps the Fed worried that it had left the rate too low for too long. The inflation rate peaked at 9 percent in June 2022, then began to fall. By August 2023 it was down to 3.7 percent, and the Fed stopped raising the IORB rate. In the year since then the inflation rate has fallen to 2.6 percent.
Lower spending means businesses are less likely to raise prices. It also means they are less likely to hire employees. They won’t hire workers to produce products that people won’t buy. The unemployment rate was 3.6 percent in March 2022, near a 50-year low. It began to rise as businesses reduced hiring. Last month it was 4.2 percent.
That’s still a low unemployment rate. But, the Fed must be thinking, with inflation on the way to the 2 percent target, why risk further increases in unemployment?
So last week the Fed cut the IORB rate by half-a-point to 4.9 percent. It’s now less attractive for banks to hold reserves at the Fed. Banks will take some of their reserves from the Fed and look for borrowers. In the short term they’ll lend to each other at the federal funds rate. With more money to lend, that rate will decline.
For the longer term, they’ll need to attract business and household borrowers. To do that, they’ll reduce their interest rates on business and mortgage loans, so that lending will increase.
Suppose a retailer wants to expand, or a family wants a new house, but they just couldn’t swing it at the old higher interest rates. Now borrowing makes sense. With their new loans they hire construction firms to build a store or a house. More construction workers are employed. The construction firms buy building materials and equipment, and the businesses that supply those things rev up their production, employing more workers. The retailer buys shelves and cash registers, the family buys appliances and furniture. Manufacturers increase employment.
The newly employed people earn more income, and increase their spending, providing reasons for other businesses to increase production and hiring.
The Fed cuts the IORB rate so lending and spending increase. The economy expands, with more income, more profits and especially more employees.
A half-point cut in the IORB rate, and the federal funds rate, is big. Usually the Fed changes rates in quarter-point steps. This time, perhaps the Fed is worried that it left rates too high for too long.
