by James Corbett, The International Forecaster:
So unless you’ve been living on Mars this week you’ll no doubt have heard that the Federal Reserve just raised their federal funds rate target, exactly as expected. But what does this even mean, and how it will impact markets in America and around the world?
Let’s peel back some of the financial gobbledygook to understand what is actually happening and what is likely to result from this week’s move.
1. The Fed did not just raise interest rates
It’s important to understand that the headline that you’ve seen a million times this week, “Fed raises interest rates,” is, technically speaking, a lie.
Firstly, the interest rate that the Fed is targeting is not one that people will be paying on their car or home loans. Specifically this has to do with the federal funds rate, or the rate at which banks and credit unions with reserves at the Fed lend those reserves to each other in the overnight market. Since the actual rate (known as the “effective federal funds rate”) is just the average of all of the rates that individual banks agree to lend/borrow from each other, it varies all the time, and the Fed targets a specific rate (or in this case a range of 0.25% – 0.5%) and tries to keep it there. Yes, this influences the rate at which you’ll be able to get a business or personal loan, but the effect is indirect. This means banks can jack up their prime lending rates and “forget” to increase deposit rates.
Secondly, and most importantly, the Fed does not “set” the federal funds rate directly. It sets a target for that rate and then tries to influence the actual rate to line up with that target. In times past, this has meant that the Fed engages in open market operations in order to pump money into the system (buying securities from banks with Fed funny money conjured out of nothing) or suck money out of the system (selling securities and taking the proceeds out of circulation). When reserves are expanding, money is “cheap” and banks will lend to each other at lower rates, and when the monetary base is contracting it has the opposite effect.
Why is this important? Because…
2. The Fed cannot use open market operation to influence rates this time around
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