NEW YORK (TheStreet) -- In the next few weeks, depending on a number of factors -- the health of the U.S. economy, the latest jobs numbers, the strength of the dollar and the pace of inflation -- the U.S. Federal Reserve may decide to increase interest rates. The decision, whatever it is, will have wide-ranging effects on the markets.

In fact, the move to increase interest rates could itself be a crucial turning point for the entire U.S. economy and trigger a chain of events. It's been nine long years since the last increase, when the interest rates were increased by 25 basis points to 5.25% in June 2006.

The intense financial crisis in 2007 and 2008 caused the toughest financial constraints on the U.S. economy since the Great Depression. In order to stabilize the economy, one of the actions taken by the Fed was to reduce the interest rate to zero. The aim through Zero Interest Rate Policy (ZIRP) was to push savers to become investors in order to jumpstart an ailing economy. Since 2008, the short-term interest rates have been kept close to zero in order to revive the economy, something that Japan resorted to in 1999 to curb deflation.

Relevant actions related to Fed rates are taken depending on the situation of the economy. An increase in interest rates when the economy looks strong and decrease when economy faces recessionary conditions.

Tools to Implement Monetary Policies

The Fed meets eight times a year to decide how to use monetary policies to meet its economic goals. The monetary policy indirectly helps in achieving high employment, stable prices (low inflation), sustainable output and moderate interest rates. The three tools of monetary policies used by the central banks are:

  1. Open Market Operations (OMO): Considered to be the most flexible method OMO involves buying and selling of government securities.
  2. Discount Rate: Interest rate charged by Federal Reserve Banks to depository institutions on short-term loans.
  3. Reserve Requirements: Minimum capital requirement that banks must maintain either in their vaults or on deposit at a Federal Reserve Bank. By lending back and forth, banks try to maintain this requirement, which helps in preventing bank failures.

What Are Fed Funds Rates and How Do They Work?

Banks are required to hold minimum reserves with the Fed. By the end of day, if any bank runs short of cash to maintain the minimum requirement, it borrows from other banks. A bank with excess cash, which is often referred to as liquidity, will lend to another bank that needs to quickly raise liquidity. Federal Funds Rate is the interest rate which banks charge each other on these overnight loans. Because lending between banks is a private transaction, the Fed cannot dictate the Fed funds rate, but instead tries to influence the rate by controlling the money supply in the system.

Through Federal Open Market Committee (FOMC), the central bank can decrease the money supply in the markets by selling government bonds to its member banks. More specifically, the central bank decreases liquidity by selling government bonds. The payments from the banks are collected by withdrawing money from their reserve accounts. Once this is done, it leads to less money in reserve accounts, which means less money supply in the banking system. Quite the contrary happens when the Fed decides to expand the economy by buying government bonds.

Thus by trading securities, the Fed influences the amount of bank reserves, which affects the federal funds rate, or the overnight lending rate at which banks borrow reserves from each other. In doing so, it triggers a series of events that eventually lead to changes in other short-term interest rates.

Why Are Interest Rates Changed?

Usually, the Fed raises interest rates to control inflation. If the interest rates are left low for too long, inflation is likely to take hold of the economy. In order to keep prices under control, the Fed decides to increase interest rates. Even a small change in the interest rate can have a profound effect on the economy therefore, the Fed tends to gradually change the interest rate by a quarter of a percent at a time.

When Do Interest Rates Rise?

The decision to increase or decrease interest rates depends on many economic factors that help officials decide whether the economy is ready for an interest rate increase or in need of a reduction in interest rates. In making its monetary policy decisions, the FOMC considers a wealth of economic data, such as: trends in prices and wages, employment, consumer spending and income, business investments, and foreign exchange markets.

According to Federal Reserve vice chairman Stanley Fischer, while deciding on monetary policies, the Fed considers factors that perceive where the economy is heading rather than where it has come from.

What Happens When Interest Rates Rise?

Even though the Fed has no direct role in setting the prime rate, it indirectly makes banks adjust their prime rates based partly on the target level of the Fed funds rate. When the Fed raises the Fed funds rate, economists call it a contractionary monetary policy (reduced interest rates is an expansionary policy) as it indirectly causes the economy to contract.

An increase in Fed funds rate indirectly increases the borrowing cost for its customers and decreases disposable income. By encouraging people to spend less and save more, the demand for goods and services drops causing inflation to fall. Hence, a rise in interest rates slows down the economy and controls inflationary pressures. Borrowers under floating rate loans are adversely affected as they end up paying more than usual. According to Investopedia, it usually takes 12-months for an interest rate to be felt in the entire economy. Having said that, instant reactions that may be short-lived are usually captured in the stock markets.

Why Is There Uncertainty on the Fed's Rates?

Amidst global turmoil, it has been difficult for the Fed to reach a conclusion about raising the interest rates. An increase in rate means that U.S. economy has shown a positive economic data that reflects low unemployment rates, controlled inflation and good economic prospects. As the factors that kept the inflation below the Fed target have begun to disappear, the officials of the Federal Reserve, in their own words, "need to consider the overall state of the US economy as well as the influence of foreign economies on the U.S. economy." For instance, Amidst many uncertainties, in his speech at Jackson Hole, Wyo., Stanley Fisher did not rule out China's influence on the interest rate decision and said, "At this moment, we are following developments in the Chinese economy and their actual and potential effects on other economies even more closely than usual."

Any wrong decision by the Fed could lead to damaging the economy rather than stabilizing it. Hence, the Fed will make this decision with a lot of caution. If the Fed does decide to raise the interest, it will be a gradual process.

 

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.