Written in collaboration with Wealth Management Research
You may occasionally hear about the Federal Reserve, or Fed, raising or lowering interest rates. Perhaps you’ve wondered what these rate changes mean for your own finances. Let’s take a look at what the Federal Reserve does, how its work affects national and global financial markets, and how those markets can then affect you.
What is the Fed, and what does it do?
The Federal Reserve, or Fed, is the United States’ central bank. It was created in 1913 to be a nonpartisan, transparent federal agency to regulate financial institutions, set U.S. monetary policy, and promote the stability of the national economy and finance system.1
The Fed does this by managing the cost of borrowing and saving. The Fed’s Federal Open Market Committee (FOMC) meets at least eight times a year to determine whether changes to the federal funds rate—commonly referred to as “interest rates”—are necessary. This rate serves as a key tool for influencing financial conditions across the economy, with the ultimate goal of maximizing the rate of employment and maintaining stable prices.2 The federal funds rate is a very short-term overnight rate, but borrowing and lending rates across the economy will often directionally follow changes in federal funds target. When the Fed raises or lowers the target range for the federal funds rate, it is attempting to influence demand, on the margin, to meet its two objectives.
How does the federal funds rate affect your life?
Short-term interest rate levels influence what it costs to borrow or save money. Here are some of the changes that can occur when rates change and how they might impact your financial situation. Note that there are long lags between rate changes and the impact on the economy.
When rates go down…
When the Fed lowers the federal funds rate, it is trying to stimulate economic activity by reducing the prime rate, which is used to calculate the interest rate on Home Equity Lines of Credit (HELOCs) and business lines of credit. When the cost of borrowing declines, it can encourage consumers and businesses to “pull demand forward” and buy something now they otherwise would have saved for and bought in the future. Likewise, individuals may be willing to pay more for something they were already planning to buy, such as a more expensive car.
Increased consumer spending can lead to companies hiring new employees to meet demand. Companies are also more likely to invest in infrastructure and new projects when the cost of borrowing dips.
Borrowing may be cheaper, but the lower rates reduce the interest savers earn from their money market fund investments. This may cause savers to reduce their spending or look for assets with higher returns.
When rates go up…
When the Fed increases interest rates, the cost of borrowing gets higher. It also can be harder to qualify for a loan when the rates are higher. Individuals may be more likely to save to take advantage of higher interest rates, and may put off large purchases for later, which can slow demand.
Slowing demand can cause companies to post fewer job openings or slow down investment in new projects, like purchasing additional equipment or making business infrastructure investments.
Federal funds rates and the Fed’s decisions are intertwined into many aspects of financial life. This article just scratches the surface of how interest rates can affect your life. Learn more at the Federal Reserve’s government website, “The Fed Explained,” which includes information about policy, supervision, and regulation, and how their work affects consumers every day.
1 The Fed Explained - Who We Are
2 The Fed Explained - Monetary Policy
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