Does the Fed Funds Rate, the rate charged by the Federal Reserve to make short-term loans to banks, directly influence the interest rate consumers and businesses pay on credit cards, mortgages, and consumer and business loans? If you took the word of the average business news commentator, you would think not. But the answer, of course, is yes.
One way to view the market rate of interest, although certainly not the only correct or useful way, is to think of it as a base rate that represents the risk-free rate, a rate that compensates the population for its impatience to consume the goods it would have consumed had it not lent the funds out in the first place. This risk-free rate is also influenced by the efficiency and functioning of the capital markets that bring borrowers and lenders together.
A risk premium is then added to this base rate of risk-free interest, one that varies depending on the degree of uncertainty of the lender getting repaid. The risk of default, the risk of prepayment, the risk of political uprising, exchange rate risk, and many other sources of uncertainty -- including the risk of inflation -- raise the level of the risk premium commanded by lenders in the market. As an example, over the last 100 years or so, the average annual risk-free rate in the U.S. has been about 4%, and the average annual risk premium for equity securities has been about 8%, bringing the average annual observed interest rate or rate of return to about 12% on these securities.
So what happens to the interest rate charged to consumers and businesses when the Fed raises the fed funds rate? Basically, the level of the risk-free rate in the economy rises and, as debt contracts expire or new lending takes place, this higher base rate gets factored into the market rate of interest charged.
Overall, the demand for loanable funds falls, the aggregate demand curve for the economy falls, and equilibrium output and employment fall, RELATIVE to where they would have been without the rate increase. The bright side is that a reduction in the money supply that accompanies an increase in the fed funds rate is absolutely essential to curtailing inflation, which drives the risk premium, and represents a much greater cost to the economy.