If you’ve ever borrowed money or opened a savings account, then the Federal Reserve matters to you.
The US central bank just raised its benchmark interest rate for the first time in a year – to a target of 0.5% to 0.75% – and signaled that there are more increases to come. That rate, called the Fed funds rate, serves as a benchmark for basically every interest rate on the planet: Government borrowing rates, mortgage rates, credit-card rates, savings account yields, and so on. The Fed uses it as a way to accelerate, or slow, economic growth. The rate is rising because the job market is relatively strong and the central bank doesn’t want prices rising too fast. Making it costlier to borrow will eventually slow spending by companies and consumers alike.
So, even if you’re not a titan of finance, the Fed’s interest rate decision could still affect you if you’re planning to buy a house or save for retirement. Here are some of the major ways the Fed can impact the lives of everyday Americans.
The Fed’s main monetary policy tool is the Federal Funds Rate.
This is the interest rate banks charge other banks for short-term loans. They borrow from each other to make sure they have enough reserves in house at any given time. The Federal Open Market Committee (FOMC) decides on a target rate, and the Fed buys and sells securities like US government debt to maintain that rate.. In the wake of the financial crisis, the Fed lowered the target rate to 0%, where it stayed for nearly 7 years before being increased to 0.25% – 0.50% in December 2015, and to 0.50-0.75% in December 2016.
Prime loan rates are established by private banks as a baseline rate for loans to businesses and consumers.
Prime rates tend to closely track the fed funds rate. As we will see, that baseline rate affects interest rates for several other forms of borrowing and saving. Between December 2008 and December 2015, the era when the Fed held the target funds rate near zero, the prime rate among the 25 largest banks stayed steady at 3.25%.
Since the first rate hike in 2015, the prime rate has notched up accordingly to 3.5%. The Fed’s decision Wednesday to move the fed funds rate up for the first time in a year is already making its way into the prime rate, with at least a dozen major banks announcing that it has increased to 3.75%.
Interest rates for major consumer loans tend to move along with the prime rate, and thus the Fed funds rate.
Interest rates for two year auto loans are usually slightly higher than the prime lending rate, so if that begins to rise, consumer loans will likely follow.
Credit card interest rates have been quite a bit higher than the prime rate, but still loosely track the underlying baseline rates.
Over the last 20 years, which is the extent of the data available through the St. Louis Fed, credit card rates more or less rise and fall along with the prime rate and Fed funds rate.
The cost of borrowing for large companies is also affected by the Fed.
The average corporate bond yield for those companies with the highest credit rating from Moody’s also tends to be affected by moves in the Fed funds rate.
The Fed funds rate also has a huge effect on the cost of short-term government borrowing.
The yield, or effective interest rate, on two-year US Treasury bills almost perfectly tracks the Fed funds rate.
Longer term government borrowing rates are also affected by the Fed. These rates are already rising though.
The yields on 10-year Treasury notes tend to move along with the Fed Funds rate, although not quite as closely as the shorter term rates. 10-year yields have been rising lately anyway, as traders anticipate more inflation as a result of of president-elect Donald Trump’s trade policies and infrastructure investment plans.
Those longer term government borrowing rates are extremely important if you’re looking to buy a house.
Standard 30-year mortgage rates tend to be correlated to 10-year Treasury yields. So, a rise in intermediate range Treasury yields could lead to higher mortgage costs.
Savers are also strongly affected by the Fed’s actions.
The interest rates offered on short-term certificates of deposit are very closely tied to the Fed funds rate.