The Federal Reserve (the Fed) has been highly prominent in the news media over the last few months as they debate when to begin raising interest rates. Federal Reserve decisions can have a significant impact on the economy, but the impact on individuals is not always as clear.
By law, the Fed has two primary objectives: To maximize employment and keep inflation under control. Of course, the Fed does not have a magic wand to control economic activity, but it seeks to influence economic trends through what is called monetary policy, or the ability to push interest rates higher or lower.
Higher interest rates typically ease the pace of economic expansion by making loans for everything from homes to automobiles more expensive. The slower pace of economic growth should subsequently ease inflation pressures. Conversely, lower interest rates should encourage borrowing, which should lead to higher spending and, as a result, greater demand for employees. For individuals, this can mean better job prospects or higher wages.
How do they do it?
Technically speaking, the Fed does not directly raise or lower the interest rates that individuals or corporations pay for loans or receive on savings. Such interest rates are called “market-based” rates, as ultimately they are determined by the demand for loans and the supply of savings. However, the Fed does have considerable influence over what is called the “Fed Funds” rate. This is the interest rate that banks are charged on overnight loans.
Raising or lowering the rate at which banks themselves must pay to borrow typically influences the rate that banks charge their customers for loans, or what they are willing to pay their depositors. The relationship, however, is not direct. For instance, the Fed may seek to raise interest rates, but if there is not strong enough demand for loans, banks may find it difficult or impossible to pass along the higher rates to customers.
How interest rates affect the economy
During the financial crisis in 2008, as the economy fell into a deep recession, the Fed took the drastic action of cutting the Fed Funds target rate to near zero percent. It has maintained this position since that time. Some believe the economy has recovered sufficiently and the Fed can now afford to raise rates, at least modestly. Others are concerned that if rates rise too quickly, it will dampen the rate of economic growth and potentially have a negative impact on economic growth.
What a change in rates could mean
Ultimately, any Fed decisions that affect credit markets can have an impact on us as savers or borrowers. Over time, if the economy continues to slowly strengthen, inflation pressures could become more prevalent, thus prompting Fed officials to push interest rates higher. That could mean higher mortgage rates, which might translate into having to buy a lower-priced home to afford the payments. It also may make it more expensive to obtain an automobile loan. Of course, you don’t want to make a major purchase—such as a home or car—simply because the Fed may raise rates. Ensure that any big expenditure fits within the context of your long-term financial plan.
For savers, the implications are a bit more complicated. You have savings that you want to lend (to generate interest income), but if there are few potential borrowers, or a lot of savers with funds to lend, the return on those savings could remain low regardless of Federal Reserve actions.
To this point, speculation regarding the Fed policy has had limited impact on the economy itself. Growth has remained modest but steady. By contrast, the investment markets have been much more volatile in recent months as investors tried to predict the Fed’s moves. Be prepared for continued ups-and-downs in the market, due at least in part to ongoing efforts to try to predict potential changes in direction of the Federal Reserve’s policies.
Finally, keep in mind that there are a wide range of factors outside of the Fed’s control that can significantly impact the economic situation. So although the Fed’s tools can be a powerful influence over the economy, they are by no means absolute.
William “Drew” Watson CFP® is a Financial Advisor and Private Wealth Advisor with Ameriprise Financial Services, Inc. in Owensboro, KY. He specializes in fee-based financial planning and asset management strategies and has been in practice for 20 years. To contact us by phone, please call 270-684-8424, or mail to 111 West 3rd St., Owensboro, KY 42303. You may also visit our website at www.williamawatson.com.