How Federal Interest Rates Affect the "Consumer" - A Look at the Fed and Rates/Hikes
By Christopher Levarek
“Whoever controls the volume of money in any country is absolute master of all industry and commerce.”
- James A. Garfield
Whenever the Federal Reserve(in the United States) or Federal Reserve Board, the governing body of the Federal Reserve System, take action many day-to-day consumers do not understand entirely what the purpose is or how it affects their lives. Today we go back to the basics to help shine a light on the purpose of the Fed, what Federal Interest Rate cuts mean to the average consumer and what’s on the horizon whenever these actions are taken.
What is the Federal Reserve and What purpose do they Serve?
The Federal Reserve System is the U.S. Central Bank in charge of making/controlling the country’s monetary policy. The Federal Reserve Board, or governing seven-member body controls the Federal Reserve System. In essence they are considered an independent agency from the Federal Government and handle open market operations of the federal funds rate.
The “federal funds rate” is a lending interest rate in essence which governs the rates of interbank loans by individual banks. Adjusting this “funds rate” allows the Federal Reserve to control or drive the economy or more specifically the buying power of the economy in a specific direction. The purpose of the Federal Reserve then, at it’s base level, is to control the monetary policy by lowering rates to drive growth, subsequently increasing inflation, or alternatively raise rates to slow inflation and limit growth to sustainable levels.
When the Federal Reserve Lowers interest rates - What does it mean to the average consumer?
The Federal Reserve will from time to time, lower or cut the “federal fund’s target rate”. As this is the target rate to which banks align with for overnight reserve loans or follow for inter bank loan negotiations, this has a ripple effect on a number of areas in the economy or monetary policy. We will highlight some of the most frequently thought of affects to the “average consumer” due to a lowering or cuts of the Federal Interest Rate and address if these are indeed true :
Mortgages
It depends. With regards to mortgages, it depends on the type of financing.
Fixed-Rate Mortgages - No, not affected. As Fed rate cuts affect short-term lending rates these loans are based on long-term rates and so are not affected in general.
Adjustable-Rate Mortgages - Yes, can be affected. ARM’s or adjustable-rate mortgages are often linked to the Fed rate and payments can decrease due to a lowering of the Fed rate.
Home-Equity Loans and Lines of Credit - Yes, can be affected. Similar to ARM’s, these loans fluctuate in accordance with the Fed rate.
Savings Accounts
Yes, can be affected. With regards to savings interest rates, banks will lower rates in accordance with the Fed cut and lower rates will be given on CDs(certificates of deposit), money market and savings accounts. For those already owning a CD, this is a locked rate however any new CDs will be affected at newer rates.
Credit Cards
It depends. With regards to credit cards, it depends on the type of financing.
Fixed Rate - No, not affected. For Fixed-rate credit cards, a Fed rate cut usually has not effect.
Variable Rate - Yes, can be affected. For variable-rate credit cards, as the rate is linked to prime or the Federal rate, lower interest rate charges should be on the horizon.
In Final
As discussed, a “federal rate cut” is put into place to increase spending as borrowing money becomes cheaper. Although this can be good in the short term and acts as a balancing mechanism for the Federal Reserve to control monetary policy, it eventually leads towards increased inflation which then leads to a lowering of purchase power overall.
In many cases, when the Federal Reserve cuts the Federal Rate, a recession is either in progress or on the near future. In an attempt to delay or halt the recession, the cut is meant to keep the economy humming or ensure purchasing continues. This will lessen the severity of a recession at times but markets need to adjust naturally and inevitably a recession is necessary to “reset” the clock so to speak on the economic markets.
We advise to constantly watch the markets for indications of changes and fluctuations that present opportunity whether the rate is being cut or increased. Be vigilant during economic peaks and downturns, there are opportunities or advantages to both points in the cycle. Invest Smart!