Applying the Brakes

Chart of the Week for August 27-September 2, 1999

The Federal Reserve’s Federal Open Market Committee (FOMC) raised its target for the federal-funds rate to 5.25% as expected last Tuesday. The federal-funds rate is the rate at which banks lend to each other overnight.

The FOMC changes this rate based on its anticipation of future economic growth and/or inflationary pressures. The FOMC stated that this rate increase “should markedly diminish the risk of rising inflation going forward.”

Within hours after the announcement, most large U.S. banks had increased their prime lending rate to 8.25% from 8.0%. Rising interest rates flow through to consumers in the form of higher rates for mortgages, consumer loans, and credit card debt. As a result, rising interest rates tend to dampen consumer spending and slow the economy.

The chart above plots out the history of the nominal and real federal-funds rates through the 1990s. The real fed funds rate is the nominal rate minus inflation, and reflects the true cost of borrowing. During parts of 1992 and 1993, banks were borrowing at real rates of around 0%. Even though inflation is currently near record lows, the real rate today is slightly higher than the decade average. This is explained by the Fed’s merciless pursuit of price stability.

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