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Everything you need to know about the Federal Reserve’s decision to raise interest rates

(Xaume Olleros/Bloomberg)

The Federal Reserve announced Wednesday it was raising rates for the first time in nearly 10 years: raise interest rates. The decision sounds wonky, but it is momentous for the nation's economy. Hiking rates mark the end of a historic effort to lift growth and create jobs -- an effort that has had decidedly mixed results. Unemployment is down, but workers aren't getting meaningful raises, and there's still a general sense that the economy isn't as strong as it could be.

When the Fed raises interest rates, the cost of all sorts of other loans, from mortgages to credit cards, will likely also go up. Lending is the lifeblood of the economy, so any change could affect not just the price of borrowing but the stock market, the jobs market and the value of the dollar. Policymakers from Mexico to Zambia are bracing for wild swings in financial markets. It will also mark a new chapter in the America's recovery, a sign that nation's economic stewards believe it is relatively safe from the risk of a sudden downturn. Not everyone agrees, however.

Understanding what the Fed is, and why the Fed does what it does, can be pretty complex. Here's what you need to know.

What exactly is the Fed?

The Fed is the nation’s central bank. One of its main missions is to make sure the economy is healthy. What does healthy mean? That there are jobs for everyone who wants one and the cost of goods and services are stable.

It has a few ways of trying to achieve that balance, but arguably the most important is setting a target for the interest rate that banks pay to borrow money from each other overnight -- the federal funds rate. It’s one of the least risky loans of all, so it essentially sets the basis for all other borrowing across the country.

It seems like a simple thing, but decades of economic analysis and experience show that that simple thing has enormous power over economy.

What does the Fed need to decide now?

The Fed needs to decide whether to raise the fed funds rate -- and consequently, all interest rates -- or stay put. In October, the central bank explicitly called out its meeting this week as the potential moment of truth. Investors have taken the hint: Odds that the Fed will vote Wednesday to raise rates have topped 80 percent.

The decision has been a long time coming. The Fed has repeatedly pushed back the goal post since slashing its target rate to zero during the financial crisis. First it promised to stay at zero at least until 2012. Then 2013. Then mid-2015. Then until the jobless rate fell to 6.5 percent or inflation rose above 2.5 percent.

Finally, Fed officials forecast that the first interest rate hike since the iPhone was introduced would happen sometime this year. Many analysts thought that meant it would move in September. But then China devalued its currency and sent financial markets around the world into a collective panic attack. Remember that 1,000-point drop in the Dow Jones industrial average?

The Fed wanted to make sure the volatility wasn't a sign of deeper problems in the increasingly connected global economy. Officials voted to keep the target rate at zero in September but continued to predict the decision would come this year. Markets have stabilized since then, and China's yuan has even been blessed by the International Monetary Fund as one of the world's elite currencies.

The meeting this week is Fed's last one in 2015.

But how does the Fed affect me on a daily basis? 

The Fed wants a healthy economy, and ultimately, a good economy can help decide whether you have a job, or a good job, that pays enough so you can afford what you need to live a happy life.

In the short term, when the Fed raises its target rate, interest rates on everything from mortgages to car loans to factory equipment generally go up as well. And when the Fed lowers the target rate, borrowing gets cheaper. Because the Fed cut its rate to zero, you can get mortgage loans these days for 4 percent or auto loans at no cost. (Just don't tell your parents or grandparents, who will remember having paid in the double-digits for a loan.)

If you doubt the central bank’s influence over your wallet, just look at what happened in 2013. Then-Fed Chair Ben Bernanke merely hinted that he might be ready to slow the Fed's efforts to boost the economy. Markets panicked, and interest rates spiked across the board.

Mortgage rates for a 30-year fixed-rate loan went from an average of 3.41 percent in January to 4.46 percent by the end of the year -- a full percentage point jump. Imagine buying a single-family home that year at the median price of $197,400, with a 20 percent down payment. The jump in interest rates translates into an extra $95 a month -- and $34,267 over the life of the loan.

Tell me more about Janet Yellen. Does she play the same role as Ben Bernanke and Alan Greenspan?

Janet Yellen is the chair of the Fed, taking over the post last year from Bernanke before her and Greenspan before him. (Side note: She's the first woman to ever hold the position.) She's pretty close philosophically to Bernanke and served as vice chair during his tenure.

Yellen believes that the Fed can play an important role in helping the economy return to normal. She is a staunch supporter of the massive stimulus the Fed unleashed under Bernanke to help the country avoid another Great Depression. She is less worried about prices spiraling out of control and more worried about the number of people who are unemployed or underemployed. In the wonky world of Fed watchers, that makes her a "dove" -- as opposed to a "hawk" who is more worried about inflation.

What’s the case for raising the fed funds rate now?

Higher rates in a stronger economy is part of the natural order of the world. But timing is everything: Move too soon, and the Fed could undermine the recovery’s momentum. If people can't get affordable loans, they can't invest in new hires or new equipment or new houses.

But move too late, and it risks allowing the economy to overheat, causing stock market bubbles or the type of inflation that you sometimes see in other countries, where prices are going up so fast that people's incomes have trouble keeping pace.

The Fed tries to balance these two concerns, pushing the jobless rate as low as possible while also ensuring that prices don’t rise too quickly or too high.

Those who think it’s time for the fed funds rate to rise are generally worried that the central bank is risking too much inflation. They make two arguments.

The first points to the unemployment rate for justification. The national jobless rate was 5 percent in November, down from a high of 10 percent just after the recession and close to what many economists believe is its lowest sustainable level. They argue low unemployment is a sign that the economy is heating up so much that businesses and consumers will start spending more freely. That allows companies to charge more for their products, which in turn encourages workers to demand higher wages, and inflation starts to rise

Because monetary policy operates with long lags, any action by the Fed now could take a year or more to filter through to the economy. Former Dallas Fed president Richard Fisher, king of metaphors, likened monetary policy to duck hunting: Shoot where the duck is going, not where it’s been. So if it acts now, the Fed could avoid overheating later on.

The second argument is that so many years of easy money are creating dangerous risks for the economy. The (until recently) record highs in stock markets, the record low yields in bond markets, even the long-awaited but now substantial rise in housing prices -- all have been labeled with the dreaded b-word: bubble. So according to this thinking, the Fed should raise rates to reduce the incentives for investors to make risky bets.

Sounds scary. Why would anyone want them to wait?

Despite what some of the statistics suggest, it’s not really so clear that the economy -- and more precisely, the jobs market -- is really as strong as it seems. Even though the unemployment rate is 5 percent, there’s a large shadow workforce that isn’t reflected in that number. They include people who have gotten discouraged about their job prospects and dropped out of the labor market. Others are working part-time but would really like full-time jobs. Even those with full-time jobs may have settled for positions that don’t use all of their skills.

Wage growth, meanwhile, has been stuck at about 2 percent for years, well below the 3 to 4 percent average of previous decades.

That argument hits a nerve with Yellen, who is a labor economist by training and has frequently cited these issues as signs of underlying weakness in the labor market. If the job market is not really as strong as the unemployment rate suggests, inflation is probably farther off -- and the Fed can afford to wait longer before making a move.

The Fed has set a 2 percent target for inflation, and right now price changes are running well below that. In fact, inflation is so low that some prominent economists think it’s a sign that the Fed ought to be doing more to stimulate the recovery.

Then there’s China. Even though financial markets have stabilized, the world's second-largest economy is clearly slowing down. If its leaders cannot manage the decline, other countries will suffer collateral damage. Already, emerging markets like Brazil are feeling the pain from falling prices for oil and other commodities such as steel and iron ore that China once consumed with voracious appetite.

If America hits another pothole, the Fed could be forced to reverse course and cut interest rates. Those who want the Fed to wait say that means the central bank should be totally confident that the recovery is real before making a move -- and they're not convinced yet. Besides, doing a 180 would be really embarrassing and could damage the Fed's credibility.

Is there any chance of a compromise?

The Fed sets policy through a committee vote. The group is led by Yellen but includes nine other members who have their own interpretations and frameworks for assessing the progress of the economy. Yellen has to forge a consensus among the committee members, as well as among the rest of the Fed’s top ranks.

They are all frustrated by the attention that the first rate hike has gotten. It's a big deal because it represents a shift from doing more to doing less, but the actual move is likely to be small -- just one quarter of one percent. And the central bank has repeatedly emphasized that it's the broader pace of increases that matters, not just the first move. In other words, the second, third and fourth hikes are just as important as the first.

It's that pace that is under negotiation right now. While there seems to be broad agreement among Fed officials to raise rates this week, it's unclear when the next increase will happen or what the conditions for it are. Yellen says that she expects to move "gradually." Expect plenty of debate over the next weeks and months over how to define that term.

What's your best guess?

In the fall, Fed officials forecast that their target rate would reach a median of 1.4 percent at the end of next year.  Since they hold a policy-setting meeting every six weeks, that suggests the central bank would vote to hike rates by a quarter-percentage point at every other meeting. Conveniently, Yellen also holds a press conference after every other meeting. Voila!

There's always a catch: Financial markets don't buy it. The odds that the Fed actually hits that number or beats it are roughly even right now. Some analysts think the Fed will only raise rates once before realizing they made a mistake -- financial markets might buckle, inflation could fall even lower or another recession could hit. Then the Fed, like several other central banks before it, would be forced into retreat.

In addition, central bank officials have been wary of getting locked into a predictable pattern of hikes. You know, like a rate increase at every other meeting. They have said they may move more quickly or slowly depending on how the recovery progresses, but it's a tough sell.

How high could interest rates go?

Even if the Fed hikes its target rate multiple times, it still may fall short of the historical norm of 4 percent for some time. Yellen has argued that the country’s hangover from the Great Recession has been incredibly long and painful. Many people still have difficulty qualifying for loans, and banks are sitting on record reserves. Businesses have been loathe to invest the more $1 trillion on corporate balance sheets.

Here’s how Yellen put it in a speech in Rhode Island in last spring:

The various headwinds that are still restraining the economy, as I said, will likely take some time to fully abate, and the pace of that improvement is highly uncertain. If conditions develop as my colleagues and I expect, then the FOMC's objectives of maximum employment and price stability would best be achieved by proceeding cautiously, which I expect would mean that it will be several years before the federal funds rate would be back to its normal, longer-run level.

Are you done yet?

Pretty much. All that’s left is to put your feet up, turn on Yellen’s press conference at 2:30 p.m., and indulge in a tall glass of liquidity.