You may periodically notice headlines that state one of the following:
“The Fed decides to cut interest rates.”
“The Fed hikes rates.”
”The Fed leaves rates unchanged.”
You might ask yourself… What do these mean? Which interest rates? Who is “the Fed”?
Let’s start with explaining the Fed, which is short for the Federal Reserve. It is our nation’s central bank. The Federal Reserve system aims to steer the economy in the right direction. This includes making monetary policy decisions that promote financial stability across major banks and institutions. Monetary policy consists of overseeing two essential things:
The Fed primarily monitors and adjusts interest rates, which I will focus on here. It does so by adjusting the federal funds rate. This is the rate that financial institutions use as a benchmark when issuing short-term loans. By raising and lowering the federal funds rate, the Fed helps temper inflation, liquidity and overall economic growth. As demonstrated below, the federal funds rate has a ripple effect throughout the economy, flowing all the way down to your savings account.
With a growing economy comes growing inflation. Inflation is the price increase of goods and services over time. For instance, the rising cost to buy a home. To help keep inflation from rising too quickly, the Fed may increase the federal funds rate to slow things down a bit. In contrast, to spur inflation when the economy is slow, the Fed may decrease the federal funds rate to encourage more lending/borrowing.
Let’s look closer at each scenario.
Scenario 1: Economy is too slow
Let’s say the U.S economy has been sour and the Federal Reserve recognizes this. In turn, the Fed could lower interest rates. Reducing interest rates will ideally entice consumers to spend and invest more, leading to greater demand and economic growth. Here are some outcomes of lower rates:
Credit card rates fall, which encourages more spending via debt
Basic savings rates fall, which encourages riskier investing (i.e. stocks)
Cheaper bank lending encourages business to expand via debt
Business expansion means increased hiring and/or capital expenditures
As overall economic production expands, further hiring and capital spending is needed
Unemployment falls and household earnings increase, which boosts demand for goods and services
Mortgage loans and home equity line-of-credit financing becomes cheaper
Prospective first-time home buyers may be more apt to buy, which boosts housing demand, and consequently, home values
Bottom Line: If the economy is sluggish, the Federal Reserve has the capability to lower interest rates in order to spark economic activity.
Scenario 2: Economy is too fast
In this example, let’s say the U.S economy has been growing rapidly and the Federal Reserve wants to keep the economy humming at the right pace. As a result, the Fed could raise interest rates if it thinks inflation is running too hot, meaning prices are expanding too fast too soon. By hiking the federal funds rate it slows the pace of economic activity. Here are some outcomes stemming from higher rates:
Interest payments on credit cards and car loans become more expensive, discouraging additional spending
Greater incentive to save conservatively versus riskier investing, as the rate-of-return on basic savings increases
As savings rise, consumption and investing slow
Borrowing costs become more expensive, which discourages businesses from taking on debt in order to expand
Mortgage loans become more expensive if long-term rates follow suit
Variable-rate mortgage owners will see their interest rates increase
Existing homeowners may be less apt to upgrade their home if it means replacing their current mortgage with more expensive financing
Reduced demand among existing homeowners flattens housing growth
Existing home owners may be less likely to remodel as it becomes more expensive to take on a home equity line-of-credit
Bottom Line: If the economy is growing too fast, the Federal Reserve may raise rates in order to slow the pace of economic expansion.
Whether you are buying a car or applying for a home mortgage, the federal funds rate affects you. To what extent? For the most part, it is not necessary to tune in to every Federal Reserve meeting to hear the outcome. In other words, a single Fed policy decision will not greatly impact your life. If you are considering whether to buy a home in 2019 versus 2020, there are other aspects behind your buying decision that outweigh interest rate moves, such as the purchase price, your financial health, your life circumstances, etc. The Fed is a vital component to our economy, but do not obsess over the Fed.
With that said, I encourage you to check-in with the Fed every now and again. Fed policy sheds light on the current health of the economy as well as the future outlook. Stay informed on how the economy is behaving because it could help supplement certain financial decisions you make in the future.
As of May 2019 the federal funds rate sits at 2.5%. The Fed increased interest rates four times in 2018, with no rate hikes so far in 2019. Indications are that there will be no rate hikes anytime soon, though the Fed meets periodically throughout the rest of the year to confirm or change its policy course.
If you would like more information or have other questions, please feel free to contact me directly.
Joshua J. Baird
Investment Adviser Representative