What an Interest-Rate Hike Means for Non-Economists

A primer on monetary policy

The Federal Reserve building in Washington, D.C. (Kevin Lamarque / Reuters)

The December Fed meeting began Tuesday morning, and the news surrounding it will be closely watched, as many economists and financial analysts believe that this is the meeting when the U.S. central bank will finally move to raise interest rates for the first time in nearly a decade. Ninety-seven percent of economists surveyed by The Wall Street Journal believe a rate hike will be announced tomorrow. For its part, the Fed has been hinting at a rate hike for months.

Coverage of the Fed’s decision is mostly geared towards the financial world, and will likely include a detailed decryption of Fed-speak and photos of rocketships launching—a visual representation of the “lift-off” from near-zero rates. But Wednesday’s news is worth paying attention to for everyone, not just bankers and economists. Monetary policy is the way a central bank changes the cost and availability of money—which affects anyone who is a participant in the U.S. economy.

Low interest rates have been part of the Fed’s monetary policy since 2007, when they were put in place for a post-recession recovery effort. If the Fed decides on a rate hike, it’s expected that rates will go up by 25 basis points—which means that the Fed’s target for the federal funds rate will move from between 0 percent and 0.25 percent to between 0.25 percent and 0.50 percent.

What does that actually mean? The federal funds rate is the interest rate banks charge when loaning money to each other, and the Fed sets a target range because it can’t directly manipulate the federal funds rate. Instead, it uses the means available to it as the central bank—creating or removing money from the financial system—to bring about changes that affect the federal funds rate. (Of course, this is not actually as straightforward as it sounds.)

One consequence of all this is that it becomes more expensive to borrow money. The cost of getting a loan has been close to free for the past few years, which is ideal during recessionary times: When loans are cheap, that encourages people, businesses, and investors to spend money, which stimulates the economy. That said, keeping rates low for too long can cause asset bubbles. (Inflation is also another consideration in raising rates, but current readings have been mysteriously low.)

How does this play out for the average consumer? The most common type of loans becoming more expensive are mortgages, credit-card debt, and car loans—which will indirectly become more costly as a result of an interest-rate increase. This is what’s referred to as tightening of the credit market.

The upside, though, is that saving money will become marginally more attractive: Low rates have meant that the incentive to put money away has been virtually nil—for years, savings accounts have had such low interest rates that $1,000 held for a year only turns into $1,001 or $1,002. While gains will likely soon be larger than that, banks are usually slower to raise interest rates on savings accounts than on loans. On top of that, the Fed has noted that it will raise interest rates gradually, so the magnitude of these changes will be small at first.

The bottom line here is straightforward: As Fed Chairwoman Janet Yellen mentioned in a recent speech, an interest-rate hike is a signal that the economy is improving.