Why did the Fed raise rates?

The U.S. central bank has a dual mandate of promoting "maximum employment" and stable prices. On the jobs front, much has improved since the depths of the Great Recession. The U.S. jobless rate stands at 5 per cent, down sharply from a crisis-era high of 10 per cent.



Inflation, however, remains stubbornly low, partly due to the collapse in energy prices. But in general, the U.S. economy is on much better footing and, per the Fed's assessment, can withstand a higher cost of borrowing.

"The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise over the medium term to its 2-per-cent objective," the Fed's rate-setting committee said in its policy statement.



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Waiting too long to hike rates can have adverse effects. The economy could overheat, putting significant upward pressure on prices. In such a scenario, the Fed would be forced to abruptly tighten policy, which in turn could roil markets.



What exactly is the Fed's benchmark rate?

The federal funds target rate, otherwise known as the Fed's benchmark rate, is ultimately what today's headlines are all about.

The target rate is, in fact, a range. The Fed on Wednesday raised its target range for the federal funds rate to between 0.25 per cent and 0.5 per cent. Previously, it was between 0 per cent and 0.25 per cent, a level it had been at for seven years.

All of which bears asking: What exactly is the federal funds rate?

U.S. banks and other depository institutions are required by law to keep a certain level of funds in reserve. If a bank doesn't have sufficient reserves, it can borrow from a bank holding excess funds. These short-term loans take place in the federal funds market. The cost of borrowing in this market is the federal funds rate.

But the Fed doesn't set the rate. It can, however, try to push the fed funds rate toward its target. To do so, the Fed buys and sells government securities – an activity known as open market operations – to either raise or lower the supply of reserves in the banking system, which in turn affects rates. If there are less reserves to lend out, for instance, rates should climb higher.

So why all the fuss about the fed funds rate? Because it influences other interest rates – including those that truly hit home. More on that later.

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Was the hike expected?

Yes. As of Wednesday morning, the implied probability of a hike was 76 per cent, according to Bloomberg data. Several observers had said that failing to raise interest rates would have damaged the Fed's credibility.



Will there be other hikes?

That's the idea. This is just the first step on a path back to normal.

But Federal Reserve chair Janet Yellen has long said the pace of rate hikes would be slow and gradual.



"An abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession," she said earlier this month.

Wednesday's policy statement shed further light on the path forward: "The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data. "

How are markets reacting?

U.S. and Canadian stocks built on earlier gains after the 2 p.m. announcement. The S&P/TSX index climbed 1.63 per cent on the day, while the S&P 500 closed 1.45 per cent higher.

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How have stocks performed after previous hikes? "In the past, equities in developed markets have reacted pretty well to Fed tightening," said Brian Davidson, markets economist at research firm Capital Economics, in a note.

What does this mean for consumers?

Right now, not a lot. The Fed has only hiked its benchmark rate by a quarter of a percentage point.

But the fed funds rate does influence other costs of borrowing. So as the Fed (presumably) continues to hike its target rate in the coming months and years, interest rates on everything from mortgages to car loans will also rise. Savers should eventually see more favourable rates on their deposits, too.

What does this mean for currencies?

The U.S. dollar – already riding a strong 2015 – is expected to get a boost as the Fed begins normalizing rates. That's not necessarily good news. An even stronger dollar will weigh on exports and dissuade some travellers from heading to the States. U.S. companies with sizable foreign-currency sales would see a hit to their earnings.

Also, foreign companies with U.S.-denominated debt will face even steeper debt-servicing costs if the U.S. currency climbs higher.



What does this mean for Canada?

The Canadian dollar will take a hit if its U.S. counterpart surges. By now, Canadians are used to hearing about the low-flying loonie, which is down nearly 16 per cent against the U.S. dollar this year. A weaker loonie should boost the fortunes of exporters. On the other hand, Canadians may want to reconsider any last-minute, cross-border holiday shopping they had in mind.

Finally, it's worth noting the Fed and Canada's central bank are now on very different tracks. The Bank of Canada's key lending rate stands at 0.5 per cent – following two 25-basis-point trims earlier this year – and a rate hike is not imminent. In fact, there's currently a higher probability of the BoC slashing rates than raising them, according to Bloomberg data.