One of the most common misconceptions about monetary policy is that the Federal Reserve “sets” interest rates. The reality is a bit more complicated but understanding how interest rates work can give you a better grasp on mortgage rates, credit card rates, and more.
To understand how the Federal Reserve influences rates, it’s important to understand how banks work. Why? Banks are required by law to end each day with a certain amount of customer money on hand (in reserve). Because banks don’t make money on this amount, they try to keep as close to the minimum as possible, meaning they sometimes dip below the required amount. To remedy this, banks often have to lend money amongst themselves overnight.
The banks charge each other interest on these overnight loans, and the Federal Reserve provides a target for what this rate should be, based on its assessment of the economy. Banks often stick closely to this rate, known as the Federal Funds rate.
When the Fed Funds rate increases, it’s more expensive for banks to borrow money. Logically, they’ll try to keep more money on the books, and become less likely to lend money out… unless it’s done at a higher rate. This means the prime rate (what banks charge consumers) increases, and the domino effect continues.
The converse is also true. When the Fed Funds rate goes down, banks don’t have to worry as much about keeping cash on hand. They’re more inclined to lend money to consumers, and they tend to offer better rates to borrowers.
When making a decision as to whether or not to lower rates, the Federal Reserve has a dual mandate: inflation and jobs. Those are (technically) the only two things the central bank is tasked with monitoring. However, the Fed also tends to look at overall economic trends, like GDP, as part of their decision-making process.
Recently, the Fed has also moved toward more transparency, forecasting rate changes before they happen to give banks, investors and others time to process and anticipate the changes. The Fed also holds press conferences and publishes statements, which are available to the public via the bank’s website.
Today, rates are near historic lows, a sign that the Fed thinks the economy should be moving faster. And that’s likely to continue. “I think rates will remain very low, because there is such turbulence in the economy,” said Wealthbridge founder Tim Randle. “I don’t see that going away in the next year.”
So how does all of this impact your finances? According to Randle, “It’s important to know how the Fed views our economy when you make large financial decisions.” Today’s historically low rates should translate to low rates for mortgages and debt. But it can also mean bonds yield less interest, and that might affect your investment strategy, which you can discuss with your advisor.