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. Last Updated: 07/27/2016

How Rate Rise Ripples Through the Economy

LOS ANGELES -- The Federal Reserve Board did as expected last Tuesday, tightening credit in the economy by raising a key short-term interest rate -- the federal funds rate -- from 5.25 percent to 5.5 percent. Here are answers to questions you may have about the Fed's move and its effect on borrowing, investing and the economy in general.


Q: Why exactly did the Fed decide to raise rates?


A: We may know that when Chairman Alan Greenspan someday writes his memoirs.


On the surface, despite the strong U.S. economy, there are very few signs of the inflationary pressures the Fed is supposed to fight. The Fed says it is being "pre-emptive" in trying to slow the economy -- in other words, firing before it sees the whites of higher inflation's eyes. But economist Philip Braverman at DKB Securities in New York says "this isn't pre-emptive -- it's premature."


Plus, everyone suspects that Greenspan has another agenda besides inflation: cooling what might be excessive stock market speculation.


Q: Will this be the first of many rate increases?


A: Probably not even Greenspan knows for sure. But historically the Fed has rarely raised rates just once -- there usually is a series of increases because the Fed tends to be "gradualist" in trying to affect the economy. The Fed may raise the federal funds rate another half a point at most, returning it to the 6 percent level of the winter of 1995.


Q: What's the best way to gauge the chances of more rate hikes?


A: Watch the economic data in April and May. That will tell the tale. If consumer spending, business spending, home sales and other key components of economic strength fail to weaken, the Fed will feel more pressure to raise rates again.


Likewise, market interest rates -- particularly on Treasury issues -- will signal what investors believe the Fed will do. In recent weeks, for example, the yield on one-year Treasury bills has risen from 5.42 percent to 5.88 percent -- a clear sign that the market believed the Fed would be boosting its benchmark rates.


Q: What will Tuesday's Fed rate increase mean for borrowers?


A: Banks were quick to answer that question: Many of them raised their prime lending rates Tuesday from 8.25 percent to 8.5 percent. That will raise many businesses' cost of borrowing almost immediately.


Some consumer loan rates are tied to the prime, so borrowing that way will also get slightly more expensive soon.


Robert Heady, editor of the Bank Rate Monitor newsletter in North Palm Beach, Fla., expects increases of 0.10 to 0.15 point in many consumer loans over the next months.


Q: What will savers get out of this rate increase?


A: Unfortunately, banks can be woefully slow in raising CD yields. Although Treasury bill yields have risen in recent weeks, the average yield on six-month CDs has just inched up to 4.75 percent currently from 4.74 percent a month ago, according to the RateGram newsletter.


Your best bet for cashing in on higher yields: money market funds.


Q: What will a stingier Fed mean for the stock market?


A: Wall Street almost never likes it when interest rates are going up, for obvious reasons: Higher rates mean bonds and short-term accounts are greater competition for stocks. Plus higher rates raise the cost of doing business, crimping profits.


Many analysts believe the market is in for rough sledding over the next few months, but they note that, longer-term, if the Fed succeeds in prolonging economic growth by slowing it, that's ultimately good for stocks.