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Interest Rates Will Rise in the Near Future

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After six years of an essentially zero percent federal funds rate target, it looks like rates will begin increasing soon.

The timing of that rate increase is based on the current and future strength of the economy.

However, we get clues about when the rate increase will occur from speeches and interviews of voting members of the Federal Open Market Committee, which is the Federal Reserve’s policy-making committee.

Federal Reserve Chair Janet Yellen reaffirmed in a speech about 10 days ago that she believes it will be appropriate to raise rates this year.

“If the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy,” she said in her speech.

But she is not the only voting member.

For instance, Fed Governor Daniel Tarullo takes an opposite view of when to raise interest rates. “In my view, it likely will not be appropriate to begin raising the federal funds rate until sometime in early 2016,” he said in a presentation May 4.

Richmond Fed President Jeffrey M. Lacker, a voting member this year of the FOMC, was quoted by Reuters last week saying, “What I’ve said is that a case might be strong in June. I still think that’s possible. But as I said . . . I haven’t made up my mind yet about June.”

The upcoming rate increase is good news.

It means that the FOMC members believe the economy is strong enough to continue growing with higher interest rates. Yet, policy makers also are concerned that a premature rate increase could dampen the recovery if it is still not strong enough.

The rate hike also is great news for savers. When the Fed raises the federal funds rate target, which is the rate that banks use when they borrow from each other on an overnight basis, banks then increase the rate they pay depositors.

The iMoneyNet money fund average, the seven-day average yield over all taxable money market funds, is currently 0.02 percent in the nation. Late in 2008, when the federal funds rate target was 0.50 percent, the money fund average was 1.22 percent.

Some analysts believe that the federal funds rate target will eventually get back to a more normal rate of 3 percent over the next two years. If historical relationships hold true, savers will see a money fund average around 3 percent as well. This would certainly help retirees who are on a fixed budget.

On the other hand, borrowers will find that it costs more to get a home mortgage or to use a credit card.

The interest rate on many loans is tied to either the prime lending rate or LIBOR. The prime rate is currently at 3.25 percent and the one-month LIBOR is 0.18 percent.

In 2008, we saw how quickly the prime and LIBOR rates fell when the Fed dropped the federal funds rate.

While the federal funds rate target stood at 3 percent in February 2008, the prime rate was 6 percent and the one-month LIBOR rate was 3.14 percent. It dramatically changed by November, when the federal funds rate target was 0.50 percent and the prime rate was 4 percent and the 1-month LIBOR rate was 1.44 percent.

Longer-term interest rates also typically rise with increases in the federal funds rate, but are more dependent on inflation expectations.

The average rate for a 30-year fixed mortgage was 3.87 percent as of Thursday, up from 3.84 percent a week earlier and matching the level at the end of 2014, mortgage lender Freddie Mac said. The average 15-year rate increased to 3.11 percent from 3.05 percent.

A forecast from Chmura Economics & Analytics expects the 30-year fixed mortgage rate to rise to 6 percent by the end of 2016.

For now, it looks like higher interest rates are still possible by year’s end.

As many Fed officials say, the exact time of liftoff is data dependent. But it’s important to track FOMC member comments because not everyone interprets the data the same way.

(This column first ran in the Richmond Times Dispatch in June 2015)

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