The federal Reserve can cause an increase in interest rates in an attempt to

The Fed, as the nation’s monetary policy authority, influences the availability and cost of money and credit to promote a healthy economy. Congress has given the Fed two coequal goals for monetary policy: first, maximum employment; and, second, stable prices, meaning low, stable inflation. This “dual mandate” implies a third, lesser-known goal of moderate long-term interest rates.

The Fed’s interpretations of its maximum employment and stable prices goals have changed over time as the economy has evolved. For example, during the long expansion after the Great Recession of 2007–2009, labor market conditions became very strong and yet did not trigger a significant rise in inflation. Accordingly, the Fed de-emphasized its prior concern about employment possibly exceeding its maximum level, focusing instead only on shortfalls of employment below its maximum level. In this newer interpretation, formalized in the FOMC’s August 2020 “Statement on Longer-Run Goals and Monetary Policy Strategy, Federal Reserve Board of Governors, August 27, 2020.

The interest rate the Fed has control over is commonly referred to as the fed funds rate. This is the overnight rate that banks borrow from the Fed and it directly and indirectly affects many other rates such as prime and U.S. Treasury rates, which in turn, affect things like mortgage rates, savings and CD rates, credit card rates, and many others that touch our daily lives. (Banks borrow and lend money to other banks overnight so they can meet regulatory requirements and ensure they are prepared for the next day’s market.)

Let’s take a look at some of the many ways that your finances can be affected by changes in the fed funds rate. 

Why the Fed alters the fed funds rate

Congress created the Federal Reserve in 1913 to help improve the economy and social welfare. A major goal of the Fed is to keep prices stable, and they can take action to help stop prices from falling or rising too fast by raising or lowering the fed funds rate. When inflation is too high, the Fed can raise the rate to help slow the economy and attempt to lower inflation. On the other side of the spectrum, if inflation is low and the economy needs a boost, the Fed can lower the rate to help stimulate the economy — hopefully while keeping inflation at a moderate level. 

The effects of interest rate changes

To better understand how your finances can be affected by the Fed’s interest rate changes, it can help to look at a few examples of ways that these changes tend to affect financial products and consumer habits.  

The prime rate
The prime rate, or prime, is an interest rate that banks commonly use to determine the rate on loans to their customers. When the Fed changes the fed funds rate, prime immediately changes by the same amount. When prime rises, banks increase their variable-rate borrowing costs for their products, such as credit cards, home equity loans, and lines of credit. 

Savings rates
When the Fed raises rates, it leads to savings products like money market accounts and certificates of deposit (CDs), having higher interest rates, which can help consumers earn more money on their savings.  

Mortgage and auto loan rates
Car companies often benefit when the Fed lowers rates as consumers can better afford to buy new cars when auto loans come with lower interest rates. The same goes for home purchases. Higher interest rates increase the cost of borrowing money to buy a home, which may make the housing market less competitive for buyers, while the opposite is true when interest rates on mortgage loans are lower.  

Bond prices
Changes in interest rates can also affect other financial products, such as bonds. The effects of interest on bonds are complex, but in general, rising interest rates are detrimental to fixed-income investors that do not hold their bonds to maturity, as a rise rates causes bond prices to fall. 

Consumer spending
When the Fed raises interest rates, customers typically spend less, especially on large purchases, as credit card debt and other lending products like personal loans and mortgages become more expensive. While slowing consumer spending will tend to lower inflation, consumer spending makes up 70% of the U.S. economy, so it will also slow the economy. This is the careful balance the Fed tries to keep when it attempts to lower inflation.  

The takeaway

Interest rate hikes or declines can significantly affect consumer finances. When the Fed alters interest rates, the effect spreads throughout the entire economy, from how individuals save to how they spend to how they invest to how they borrow money. Understanding these connections can help you be financially prepared for future interest rate changes. 

For more information on how changes in interest rates impact your money, reach out to one of our bankers or stop into your local branch.

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