This new guide will show you everything you need to know about Fed interest rates.
First, I’ll show you what the Fed is and how it affects the interest rate market.
Then, I’ll help you understand what a rising rate environment means for you.
Sound good? Let’s dive right in…
What is the Federal Reserve ("The Fed")?
In this chapter, I’ll help you get the basics down.
So if you’re not sure what The Fed is, this chapter will get you on the right track.
Then, in later chapters, I’ll show you how this affects you.
What is The Fed?
In short: the Federal Reserve System (“The Fed”) is the central bank of the United States.
The Fed is essentially the governing body in the United States that controls the money supply.
It acts as the gatekeeper to the U.S. economy by regulating monetary policy and its banking institutions.
The Federal Reserve is the central bank of the United States that controls the monetary policy and banking institutions of the country.
History of The Fed
In the Panic of 1907, several Congressmen met to discuss their concerns about the U.S. banking system.
What were they worried about?
These men were concerned about future financial panics, bank failures, and business bankruptcies that would disrupt the economy.
They had also discussed the antiquated banking arrangements that prevented a more competitive banking system in the U.S.
To address these concerns, the Federal Reserve Act was passed on December 23, 1913, creating the Federal Reserve System as we know it today.
The original purpose of the Fed was to “set the nation’s monetary policy, supervise and regulate financial institutions, maintain the stability of the financial system and provide financial services to depository institutions, the U.S. government and foreign official institutions.”
How Is the Fed Structured?
The Fed is comprised of three key entities:
- Federal Reserve Board of Governors
- 12 Federal Reserve Banks
- Federal Open Market Committee
Federal Reserve Board of Governors
The Board of Governors is a group of seven individuals who are appointed by the president and confirmed by the U.S. senate.
The Fed Governors serve in 14-year terms and cannot be reappointed after their term is over.
The President is allowed to appoint a new governor every two years. This staggered schedule ensures that no president or political party can control a majority of the board.
Additionally, the President can appoint two Board members to serve as the chair and vice chair. The Board chair and vice chair serve on four year terms, but can be reappointed.
In the recent past, Alan Greenspan, Ben Bernanke, and Janet Yellen have all served as chairs of the Board.
Under President Trump’s term in office, Jerome Powell is serving as the chair of the Board.
This staggered structure is critical as it allows the Board to operate independent of politics. Instead, they can focus on the long-term growth of the U.S. economy and avoid the influence of short-term politics.
12 Federal Reserve Banks
There are 12 Federal Reserve Banks that operate throughout the country. They were established by Congress as the “operating arms” of the Federal Reserve.
The Reserve Banks execute the core mission and purpose of the Federal Reserve by:
- Supervising and examining state member banks
- Provide banking and financial services to the U.S. Treasury
- Provide banking and lending services to depository institutions
- Participate in setting of monetary policy
What’s interesting about these Reserve Banks is that they are owned by member commercial banks. They hold ownership interest in the Reserve Banks, but they do not have any voting rights.
Instead, the Board and FOMC make the Fed’s decisions.
This makes the Reserve Banks a private institution that works for the public good.
Federal Open Market Committee
The Federal Open Market Committee (FOMC) makes policies for the Federal Reserve.
Who are the voting members of the FOMC?
The chair of the board is also the chair of the FOMC. The remaining voting members of the FOMC are the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York and four other Reserve Bank presidents that rotate yearly.
This group of voting members decide on issues like interest rates and monetary policies.
How does the Federal Reserve affect interest rates?
The Fed has huge influence over interest rates.
In this chapter, I’ll show you how the Fed influences interest rates in the U.S. economy.
What is the Federal Funds Rate (Fed Funds Rate)?
The federal funds rate is the target interest rate for short-term, government securities.
Fed Funds Rate
The ferderal funds rate (fed funds rate) is the rate at which banks can borrow from the Reserve bank and between other banks.
This is the interest rate for short-term borrowing from overnight to 90-days between financial institutions and the Reserve Banks.
Why is this interest rate so important?
This rate determines the cost at which member banks are able to borrow money from the Reserve Banks.
If the fed funds rate is high, that means it is more expensive for banks to borrow money from the Reserve Banks, so they will have to charge a higher interest rate on loans it makes out to consumers and businesses.
On the other hand, if the fed funds rate is low, that means it is cheaper for banks to borrow money from the Reserve Bank. This makes the interest rates on loans out to consumers and businesses cheaper.
How does the Fed affect short-term rates?
To influence short-term borrowing rates, the Fed buys and sells large quantities of these short-term government securities.
If the FOMC wants to raise the federal funds rate, they would sell these short-term securities. If the FOMC wants to lower the federal funds rate, they would buy these short-term securities, pushing rates lower.
The FOMC typically sets a target range for this interest rate, such as 2.00% to 2.25%.
The Fed would buy or sell these securities on the open market until the market rates have adjusted to that range.
Who determined the Federal Funds Rate?
The FOMC meets eight times a year to vote on certain monetary policy decisions, interest rates being one of them.
Lately, the FOMC has been tasked with decreasing unemployment, targeting 2% inflation, and smoothing out the swings in long-term interest rates.
During the FOMC meetings, the voting members use economic data to forecast future economic growth to determine whether to hold, raise or lower the Federal Funds Rate.
Why does the Feral Reserve change interest rates?
Now that you understand how the Fed affects short-term interest rates, it’s time to learn why the Fed changes this interest rate.
In this chapter, I’ll show you why the Fed uses short-term rates to affect the growth of the U.S. economy.
You learned in the previous chapter that a lower short-term rate makes borrowing money cheaper because it costs the banks a less to obtain that capital.
If the FOMC thinks the economy needs stimulation to decrease unemployment and increase economic output, the FOMC will vote to lower interest rates.
Low interest rates sparks economic growth. This is because borrowing money becomes extremely cheap.
It’s like stepping on the economy’s gas pedal.
Since a growing economy is a good thing, why would the Fed ever raise interest rates?
The answer is inflation.
Inflation occurs when prices of goods and services increases. This makes the value of your money decrease.
If the economy grows too quickly, it can fuel rampant inflation. This means that your money becomes less and less valuable, making purchases more and more expensive.
In short: the Fed changes interest rates to balance economic growth with inflation.
What do rising interest rates mean for you?
As you may know, we are in a rising interest rate environment since 2017.
In fact, the Fed has raised rates from 0% to about 2.25% in 2017.
Percentage wise, that is a huge increase in the short-term rates.
In this chapter, I’ll show you the ramifications of a rising rate environment.
Though the Fed has been raising rates for the last year and a half, you may not have felt the impact yet.
This is because different types of financial vehicles are affected differently by a rising rate environment.
Let’s walk through several of these financial vehicles to see how they might be affected by rising rates.
Deposit Accounts (checking, savings, CDs)
- When rates go up, deposit rates go up
- When rates go down, deposit rates go down
If you are a net saver, a rising rate environment is good for you because you will earn a higher rate on your savings in interest bearing accounts.
Ever since the Great Recession in 2008 and 2009, rates on deposit accounts have hovered around 0.01% annually.
However, since the FOMC has been increasing short-term rates, deposit account rates are nearing 2.00% on savings accounts.
- When the federal funds rate goes high, mortgage rates go higher
- When the federal funds rate goes lower, mortgage rates also go lower
If you are looking to get a new home loan in the near future, you can expect to have to pay a higher interest rate.
As of this writing, mortgage rates are nearing 5% for residential mortgages.
However, if you already have a fixed rate mortgage, you are safe any increase in interest. This is because the interest rate on fixed rate mortgages stays the same throughout the life of the mortgage no matter what the current rate is.
If you have an adjustable rate mortgage (ARMS), you may see an increase in your rate in the near future.
This is because ARM loans are dependent on the prime rate. The prime rate is subject to change based on the federal funds rate.
So, if the federal funds rate goes higher, you are likely to pay a higher interest rate on your ARM.
- When the federal funds rate goes higher, credit card rates go higher
- When the federal funds rate goes lower, credit card rates go lower
Most credit card interest rates are variable, meaning that it change go up or down depending on the market rates.
Many rates are tied to the prime rate, which is affected by the federal funds rate.
In a rising rate environment, it is highly likely that rates on credit card debt will likely increase.
This may be a good time to start paying off some credit card debt before the rate increases too much.
Credit Card Example
An increase of 0.25% in interest means an additional $12.50 in annual interest on a typical $5,000 card balance.
Car loans and Student Loans
- When the federal funds rate goes up, loan rates will rise
- When the federal funds rate goes down, loan rates will also fall
For new issuances of car and student loans, you can expect to pay a higher interest rate on these loans.
This is because it costs the bank more money to borrow money from the Reserve Bank, so it must charge you, the consumer, a higher rate to make a profit.
This makes it more expensive to borrow money to buy a car or get an education.
However, if you already have a car or student loan and your rate is fixed, then a rising rate environment will not affect you at all.
Now It's Your Turn
So that’s it for my guide to Fed Interest Rates.
I hope you enjoyed it.
Now I’d like to hear your take:
Has rising rates make it more expensive for you to borrow money?
Or maybe your savings is generating a higher return?
Either way, let me know by leaving a quick comment below.