What Happens When the Fed Raises Interest Rates?

When the U.S. Federal Reserve (Fed) raises or lowers interest rates, as it did in December for the first time since 2006, it sets in motion a chain reaction, and that reaction can affect you.

By raising and lowering interest rates, the Fed is trying to maintain a healthy economy. Lowering interest rates can stimulate a slowing economy, while raising them can rein in an economy that’s overheating.

The rate the Fed adjusts is the federal funds rate, which is the interest rate banks charge each other on overnight loans. But adjusting that rate has a domino effect. When the Fed changes the federal funds rate, most banks follow by changing their prime rates – the interest rates they charge their best customers.

That can affect rates for consumer loans, and therefore impact consumer spending in a big way. To illustrate: if interest rates on home mortgages increased from 2% to 10%, would you be as likely to take out a mortgage or buy a car?

A change in interest rates can also cause confusion in the financial markets, as investors try to determine how the change will affect the economy.

When the Fed raised interest rates last December, the move had been so well advertised in advance that the market reaction was muted. Stocks, in fact, performed well the day of the announcement.

The takeaway: interest rates do matter when it comes to the market and your investments, but so do other factors, such as the price of oil, the upcoming presidential election, and global events.