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The Federal Reserve's Interst Rate Hike And What It Means For Our Members

The Federal Reserve, also known as the Fed, raised the prime interest rate by 0.25% last Wednesday.  It is the first time the Fed raised the prime interest rate since 2006.  Often, this kind of news can blur into the background, especially for young people who haven't been through an interest rate hike during their adult lives.  For those who are a little older, you may not have been in a financial position to care very much 10 years ago, but now you'd like to know what's going on.  Even if you're among those readers who are old enough to have lived through several cycles of Fed rate changes, you might want a refresher since it has been a while.

What is the Fed and why would it raise interest rates?

The Federal Reserve, chaired by Janet Yellen, is the most powerful financial institution in the United States.  Its primary responsibility is controlling how much is in the economy, which they do primarily by adjusting the rates at which banks, credit unions and others loan money.  Essentially, when the Fed wants the economy to speed up, it lowers rates, and when it wants the economy to slow down, it raises rates.

It's important to remember that we - the credit union - don't control the prime rate.  The Federal Reserve does.  Its uses this power to influence every part of the economy, from the price you pay for groceries to the unemployment rate.  As it does this, the rest of us have to deal with the adjustment periods that stem from its decisions.  Our rates for loans will have to go up.  On the other hand, our savings rates will go up as well.

If you're having trouble understanding how the Fed can control how much money is in the economy or how that affects the interest rate you pay on your mortgage, credit cards and everything else, here's a simplified example:

Imagine an island with only three things on it:  mangoes, dollars and people.  On Monday, the island has 100 mangoes and 100 dollar bills.  The price fro each mango is $1.  If one person wanted all of the mangoes, it would take all of the money, since there's no other product on the island.

On Tuesday, a plane flies by and drops 100 more mangoes, bringing the total to 200 mangoes and 100 dollars.  Now the price for each mango is 50 cents, because the supply of mangoes had gone up without demand changing at all.  Makes sense, right?  What if, on Tuesday, that plane hadn't dropped any mangoes, but instead dropped another box containing a hundred dollar bills?  Now spending all the money to get all the mangoes would take $200 for 100 mangoes, bringing the price of each mango to $2.

The Fed has the power to do this with money.  It can "print" more or less money to put it in the economy, while taking money out by paying people to keep money with them.  By the way, "print" is in quotes because the Fed actually just hits buttons on a computer and changes the balances that each bank has with it.  It's all really interesting, if you're the kind of person who finds macroeconomics interesting.

Why would the Fed ever want the economy to slow down?

The most important reason is inflation.  While the last few years have been largely free from the worst effects of inflation (1.86% per year since 2010, the lowest rate since the 1950s and roughly half of the average rate for the last 100 years), the spectre of the 20th century hangs over economic institutions today.  For most of the last 100 years, inflation has been a major factor in economic planning; Just ask any American who lived through the 1970's, which was a period of high inflation that helped motivate the Reagan-era push for free trade, deregulation and low interest rates.

Elsewhere, Brazil endured an inflation-fueled economic crisis that led to shop owners needing to increase their prices every day from the late 1970s through the early 1990s, and much of Latin America experienced a "Lost Decade" during the 1980s due in large part to foreign debt and inflation.  Perhaps most memorable from history is the German inflation crisis between the World Wars:  People were using wheelbarrows to carry their money, because it was worth so little that they needed massive amounts of bills to buy basic groceries.  The effects of the subsequent financial crisis directly contributed to the rise of Adolf Hitler and the Nazi party.

While the Fed is not worries about the rise of fascism in 21st century America, it may be worried about the example set by Japan, where fear of inflation drove their central bank to sharply raise interest rates, bursting their financial bubble and kicking off an economic slump that lasted nearly 20 years.  Paul Krugman, the award-winning economic columnist for The New York Times, argued that once of the major reasons Japan was helpless in the face of economic problems was its central banks' inability to lower interest rates, because rates were so close to zero already.  Raising rates now gives the Fed more options in the future.

How does the prime rate affect my life?

Any loan you have that is not a fixed rate loan will go up.  Credit cards, auto loans and many mortgages will have a higher interest rate than they did before, which means the amount you'll pay in interest every month will go up.  Fixed rates loans will remain unchanged.  This is why it is important to understand the terms and conditions of all of your loans and the benefits and risks associated with each one.

Overall, the Fed's decision to raise interest rates makes it better to save and worse to borrow that it was the day before.  That has a lot of effects on various parts of the economy, all of which will affect you eventually, because shaking one branch moves the whole tree.