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Understanding Federal Reserve's Impact on Rates

Katherine Reynolds Lewis: 8 ways the Federal Reserve's interest rate decisions affect your life

June 24, 2016


In December, the Federal Reserve raised interest rates for the first time in nearly a decade. And though the increase was small, it had a ripple effect.

"The Federal Reserve has its fingers in your pocketbook to a greater degree than the IRS," said Michael Reese, a financial planner in Traverse City, Michigan.

The interest rates you pay and earn, the availability of credit and even your prospects in the job market are linked to the projections and judgments of Federal Reserve Board Chair Janet Yellen and the other members of the policy-making Federal Open Market Committee, made up of Fed board governors and reserve bank presidents.

They meet in Washington to set monetary policy, primarily by raising or lowering the Fed's target for what's called the federal funds rate.

The Fed's mission is to foster economic growth without raising inflation.

"The Fed has a dual mandate. They want to have low and steady inflation and a strong labor market," said Gus Faucher, senior macroeconomist with The PNC Financial Services Group.

Making Credit Available
When the Fed is boosting the money supply, lenders are more willing to extend credit.

At the eight regularly scheduled FOMC meetings a year, committee members decide how many securities to buy and at which maturities, after they pore over data and reports from across the country on the labor market, inflation and economic growth.

The committee then unveils its new target range for the federal funds rate, and shares its members' economic projections in an announcement closely watched by traders and policymakers around the world. Within seconds, financial markets begin to adjust, affecting your pocketbook in numerous ways.

Influencing the Prices You Pay
The Fed's actions indirectly have an impact on the prices you pay at the grocery store, gas pump and other retail outlets.

That's because the cost and availability of money affect people's willingness to pay for goods and services. When money is cheap and plentiful, there's more demand and prices tend to rise.

"When the economy's doing really well and the labor market is good and the unemployment rate is falling, that's when you have concerns about employers hiring and bidding up wages and inflation rising," Faucher said.

It's easier to stop inflation than it is to break out of a deflationary cycle, said Ara Oghoorian, a financial planner in Los Angeles who previously worked for the Fed as a bank examiner.

Affecting the Job Market
At every meeting, monetary policymakers consider labor market data as they make decisions aimed at achieving maximum employment.

The Fed can only indirectly affect the job market, by lowering interest rates to encourage more borrowing. That prompts businesses to take out loans to purchase new machinery or invest in new equipment and encourages consumers to borrow in order to buy goods and services, said Faucher.

"That increases aggregate demand. Then businesses are producing more and they need to hire more workers," he said. "That, in turn, leads to a better labor market and lower unemployment rate."

Putting Credit Card Rates in Motion
The majority of credit cards charge variable interest rates tied to an index, usually the prime rate, which is about 3 percentage points above the federal funds rate. When the federal funds rate changes, the prime rate does as well, and credit card rates follow suit.

"What the Federal Reserve does normally affects short-term interest rates, so that affects the rates that people pay on credit cards," Faucher said.

When the Fed sets a low rate, you are encouraged to borrow to buy a new appliance, make home repairs or conduct similar purchases that stimulate the economy.

Nudging CD Rates
"Retirees want to live on the interest on their CDs," Reese said. "The Fed determines whether they can do that or not."

CD rates largely follow the short-term interest rates that track the federal funds rate. However, Treasury yields and other macroeconomic factors can influence rates on long-term CDs.

Individuals should focus on the real rate of return on CDs, after inflation is taken into account, said Casey Mervine, a senior financial consultant at Charles Schwab.

Driving Auto Loan Rates
The federal funds rate chiefly influences short-term interest rates, because it's a rate on money lent overnight between banks, but it also trickles through to medium-term fixed loans, such as auto loans.

"The rate the Fed sets ends up affecting almost everything in our economy," Reese said.

If a bank is charging its customers 4.64 percent for a 60-month loan on a new car, and the federal funds rate increases by a half percentage point, the lender will bump up the rate to about 5.14 percent. Auto loans also benefit from being sold into the secondary market, making more investors' dollars available to finance your car purchase or refinancing.

Turning the Key on Mortgage Rates
When the Fed lowers the federal funds rate, lenders can finance home loans more cheaply. As a result, they can reduce the interest rates they charge for a fixed-rate mortgage.

In recent years, the Fed has kept the federal funds rate low in an attempt to stimulate the housing market.

"The Fed is making homes affordable at all-time levels with low interest rates on mortgages," Mervine said.

The Fed can even control the shape of the yield curve, or the relation between interest charged for 1-year loans, 3-year loans, 5-year loans and so on.

Mortgages are pegged to the 10-year Treasury rate, because refinancings and early payoffs effectively give a 30-year mortgage a 10-year lifespan, Oghoorian said. Competition and market conditions also affect rates.

Touching Home-Equity Lines of Credit
Also directly tied to the federal funds rate: your home-equity line of credit, or HELOC. That's because HELOC rates are typically linked to the prime rate.

When the Fed raises or lowers its target rate, HELOC rates follow suit.

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