Interest Rates at Five-Year High

March 28, 2006 — -- The Federal Reserve's Open Market Committee voted to increase a key interest rate today by a quarter-point. This means that the fed funds rate -- which is what banks pay for overnight loans -- now stands at 4.75 percent.

This is the 15th time since June 2004 that the Fed has raised rates. The last time the target was set higher was March 2001.

Today's meeting marks the first time that Chairman Ben Bernanke headed the proceedings. The move helps reinforce Bernanke's promise to continue in his predecessor Alan Greenspan's footsteps as a steward of the economy. The move was widely anticipated.

Anything Else Interesting Come Out of Today's Meeting?

Economists and the markets were keen to get a peek at the post-meeting statement, looking for hints of how Bernanke's Fed sees the economic outlook.

The governors maintained some key language from the last Greenspan meeting, noting that "…some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance." It's a clear signal to the markets that we're likely to see another hike or two before the "tightening cycle" is finished.

What's likely to be noted by Fed watchers is the appearance of language in the statement that's forward-looking and a bit more transparent (revealing the governors' thoughts about the state of the economy going forward) than during Greenspan's tenure.

There were nods to the recent economic rebound (Q1 2006 looks a lot better than Q4 2005's lame 1.6 percent growth) and to the modest effects of energy being near historic highs.

The decision to boost the funds rate was unanimous as the other 10 members of the committee gave the new chairman their support. Future meetings, where the economic messages are likely to be a bit more mixed, might lead to some fracturing of opinion in the vote.

The next meeting is scheduled for May 10.

What Does That Mean?

The Fed uses interest rates like a gas pedal for the economy. When the country faces a slowdown like the recession of 2001, the Fed will lower rates to make it cheaper for companies and consumers to borrow money and continue to spend. A low interest rate -- especially one as low as 1 percent -- is like pushing the gas pedal all the way to the floor.

As the economy heats back up, the FOMC has to take its foot off the gas pedal by raising rates. Keeping rates low (flooring the economic gas pedal) for too long can spark an inflationary cycle in which the price of goods and services rises so quickly, the purchasing power of the dollar effectively plummets.

If inflation pressures increase, the Fed can put on the brakes by raising rates beyond the neutral point, which most economists believe is somewhere between 3.5 to 4.5 percent.

How Much Does This Matter?

Many consumer credit vehicles (like credit cards and home equity loans) are affected by the fed funds rate.The prime rate, a measure many consumers are familiar with, moves in lock step with the rate the FOMC changed today.

Many big-ticket credit instruments (such as mortgage rates and student loans) will not be directly affected by today's decision.

Definition: The federal funds rate is the interest rate for charged for overnight loans between banks.