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Listener Chris S. asks:
Is the Federal Reserve required to change interest rates in 1/4 point increments? Why not tenths?
The Federal Reserve raised interest rates by 0.25% last month and plans to raise its key rate six more times this year, including at its meeting next week.
The Fed can go years without changing rates, but when it does, it always increases or decreases in multiples of 25 basis points. The central bank’s decision to adjust rates by multiples of a quarter of a percentage began more than 30 years ago, in late 1989, under Fed Chairman Alan Greenspan.
“The Fed didn’t really start explicitly targeting the federal funds rate until the late 1980s,” Daniel L. Thornton, an economist and former adviser at the Federal Reserve Bank of St. Louis, told Marketplace. The Federal Reserve then began publicly announcing these goals in 1994.
“I think it’s just one of those things that they felt comfortable with,” Thornton said.
According to Gary Richardson, professor of economics at the University of California at Irvine and former Fed historian, while there is a lot of science that goes into economics, sometimes there are rules of thumb that economists s stick to it.
The Fed was not looking for the optimal percentage, he explained. “They started doing a quarter point, and it worked well because it was clear and it was infrequent and progressive,” Richardson said.
Other countries outside of the United States also change their quarterly percentage rates, such as Norway and Indonesia. However, others have changed them by a few tenths of a percent, such as China.
“If you’re going to do smaller increments, then you need to make more frequent decisions,” Richardson said. “The FOMC might think its current schedule of eight meetings a year is the right frequency.”
More frequent meetings could be a problem for staff, Richardson noted. The Fed has blackout periods a few weeks before its FOMC meetings during which employees cannot engage in certain financial transactions.
“If you increase the frequency of meetings, when are these people going to buy houses?” said Richardson.
The Fed has adjusted rates by 50, 75 and 100 basis points over the past three decades, but there are some periods when it has stuck to the traditional 25.
Between 2004 and 2006, the Fed raised rates by 25 basis points for 17 consecutive meetings. Economists said the Fed wanted to tackle creeping inflation rates, although it wasn’t too big of a problem. Between 2015 and 2018, the Fed raised the rate nine times by the same increment.
Thornton said if the Fed felt the need to adjust rates, but didn’t feel the need to act quickly, it would stick with the quarter-percentage change. If he raises those rates, getting too aggressive could spook the market.
At its next meeting, the Federal Reserve is expected to raise rates by half a percent for the first time since May 2000. A signal that the Fed thinks the economy is overheating, Richardson said.
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