So far this year, it seems like every day there’s news about what the Federal Reserve Board (FED) is going to do about interest rates. We all have heard about interest rates to an extent in our lives… whether it be interest on our savings accounts, interest we’re paying on our mortgages and car loans, or maybe even the interest rates the FED has control over and the media is discussing. But, what exactly does it mean when the FED says it’s going to raise interest rates? Is it good or bad? How will it affect you, your job, and the economy? Let’s dive in.
When we hear in the news that the Federal Reserve is going to raise interest rates, they’re talking about the Federal Funds Rate (FFR). This Federal Funds Rate is the target rate at which commercial banks can borrow or lend their excess reserves to each other overnight. Think of the FFR as the “starting rate” for interest rates across an entire economy. Of the money that consumers deposit at a retail bank, there’s rules regarding how much of those deposits the banks can lend out through loans to other consumers and businesses and how much of that money must be kept in reserves. If a bank has a shortfall of reserves, they borrow from other commercial banks that have an excess in reserves in order to meet their reserve requirement. They pay interest on that borrowing, known as the Federal Funds Rate.
So, how does this end up affecting consumers when they want to borrow money for, say, a car or save money in their savings account? Well, based on this Federal Funds Rate, commercial banks will base the interest rates they tack onto savings accounts plus the interest rates they charge on lending money out (through mortgages, car loans, credit cards, etc).
Since March of 2020, the Fed has had a targeted FFR of 0.00%-0.25% (they typically have a 0.25% range). So, it’s been near 0.00% for almost two years since the COVID pandemic hit the world. As consumers, we’ve definitely felt the impact of these near-zero interest rates on our savings accounts. It’s almost impossible to get a decent savings account yield above 0.50%! However, it’s also been pleasing on the borrowing side for consumers. Mortgages have been historically low around 2%-4% and auto loans have been cheap as well (though the prices of autos have been increasing substantially due to demand exceeding the supply). Why does the FED have the FFR near zero, you ask? They lowered interest rates to spur consumer spending. When it’s cheap to borrow, companies and individuals will spend money, thus growing the economy. When we had shutdowns that nearly locked down the economy, the Fed wanted to encourage consumers to spend their money in order to keep the economy alive.
Now, the country finds itself in the opposite situation. We’ve had substantial economic and market growth and the Fed has the position they need to “tighten” the economy by slowing down consumer and business spending. The Fed will (likely) raise the FFR in 0.25% increments 3-4 times this year. This would bring the FFR up to about 1.00% by year’s end. Now, the Fed could decide to do more or less hikes depending on their reading of the economy. As interest rates rise, consumers will begin to see the yields on their savings accounts increase as well as an increase in the cost of borrowing.
With all of this said, what are we to do as consumers, savers, spenders, and investors? If you’re planning on purchasing a home, refinancing, or taking out a large personal loan, now would be the time to potentially lock in a low interest rate. If you have some cash in the bank, you’ll likely start to see an ever-so-slight increase in what the banks are paying you to keep money with them. Other than that, stay the course with your overall financial plan and don’t get too caught up in the game of interest rates. In our lifetimes, we’ll likely see the Fed raise and lower interest rates dozens of times. If you feel the need to talk about your personal financial situation and how these interest rate changes are going to affect you personally, we’re here to help.
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