The Federal Reserve will increase interest rates when the economy is safely out of recession. The Fed traditionally increases interest rates by raising the target for the Fed funds rate at its regular FOMC meeting. This Federal interest rate is charged for Fed funds, which are loans made by banks to each other to meet the Fed reserve requirement. Technically, these rates are set by the banks themselves, not the Federal Reserve.
However, for the most part, these rates rarely vary from the target rate. This is because the banks know that the Fed will use its other tools, such as the discount window, discount rate and reserve balance supply, to create pressure on the Fed funds rate to meet its target.
On September 18, 2007, the Fed began a 16-month drive to dramatically lower rates, from 5.25% to less than 1%. This was in response to tightening credit markets brought on by the subprime mortgage crisis.
By January 2010, investors began wondering "When will the Fed raise interest rates again?" In response, the Fed announced its exit strategy, which focused on tightening money supply using everything BUT the Fed Funds rate. The Fed wants to keep that rate low, since it affects variable-rate mortgages. The housing market had not yet recovered, since it had a 15-month pipeline of foreclosures that kept housing prices down.
The Fed also must compensate for expansionary fiscal policy. On June 1, 2010, the U.S. debt hit $13 trillion. The $787 billion stimulus bill and the FY 2010 budget required record level funding from Treasury auctions. China began backing away from purchasing this debt, driving Treasury yields as higher. The yields on 10, 15 and 30-year Treasury bonds affect fixed-rate mortgage interest rates.
Therefore, the Fed's goal is to keep the Fed Funds rate unchanged as long as possible by increasing the discount rate and cutting back on other programs. This will keep the prime rate and variable-rate mortgages low, support the housing market and keep bank credit available.
How High Will Interest Rates Go?
Once the Fed raises the Fed funds rate, how high will it go? It won't go any higher than 2% in 2015. That's because inflation will remain moderate. The Fed is forecasting inflation to remain around 2.3% until 2022. With the slow economic growth we've experienced during the past five years, there's no reason for inflation to be any higher. Furthermore, the Federal government is cutting spending to balance the budget, which will remove even more stimulus, further reducing any reason for inflation.
Historically, the Fed funds rate usually stays within a range of 2-5%. The highest it's ever been was 20% in 1981 to combat stagflation, and an inflation rate of 12.9%. However, that was a highly unusual circumstance caused by wage-price controls, stop-go monetary policy and taking the dollar off of the gold standard. For more, see U.S. Inflation Rate: Current Rate, History and Forecast
Former Federal Reserve Chairman Ben Bernanke has said that the most important role of the Fed is to maintain consumer and investor confidence in the Fed's ability to control inflation. This means the Fed is traditionally more likely to raise rates to prevent inflation.
Interest rates for short-term loans and variable rate loans follow the Fed funds rate. Right now, the Fed funds rate is virtually zero. The rate on a 5-year adjustable rate mortgage (ARM) is 2.125%. Therefore, if the Fed funds rate rises to 2%, expect the loan rate to also rise by 2 points, to 4.125%.