What happens when interest rates rise

The first step is very small

The federal funds rate applies to one thing: unsecured overnight loans of reserve balances between banks. The total economic significance of that market, on its own, is minor. Its significance comes from being the anchor for everything priced off short-term money.

What moves quickly

Rates that are contractually indexed to short-term benchmarks reprice almost immediately. The prime rate, which many business credit lines and variable consumer products key off, typically moves within days of a decision. Credit card APRs follow on the next statement cycle.

Savings rates move too, but with a well-documented asymmetry: they tend to rise more slowly after increases than they fall after cuts.

What moves slowly, and why

Long-term rates are not set by the policy rate. A ten-year Treasury yield reflects what markets expect the short rate to average over ten years, plus compensation for holding a long bond.

The practical consequence surprises people: a cut that was fully expected can leave long yields unchanged, or push them up if the accompanying commentary suggests fewer cuts ahead than markets had priced. Mortgage rates, which track the ten-year, then fail to fall despite a “rate cut” in the headlines. Nothing has gone wrong — the cut was in the price already.

The lag

The effect on real activity and inflation arrives last, through investment decisions, hiring, and the housing market. Economists conventionally describe this as operating with “long and variable lags”, a phrase from Milton Friedman that has survived because no one has improved on its honesty: the delay is measured in quarters, and it is not the same length every time.

This is why the Committee is reacting to forecasts rather than to the latest data print. By the time an effect is visible, the decision that caused it is a year old.