How the Fed’s interest rate decisions impact your financial life
On Wednesday, the U.S Bureau of Labor Statistics reported that consumer prices for goods and services as measured by the personal consumption expenditures (PCE) index has climbed 9.1% over the past twelve months—a forty-year record, and the highest rate of inflation since November 1981. As supply shortages collide with consumer demand, Americans are grappling with how to afford basic necessities like food, gas, and housing as prices surge across broad sectors of the economy.
The central bank of the United States—also known as the Federal Reserve or the Fed—is charged by Congress with maintaining economic and financial stability. First and foremost, the institution steers the world’s largest economy by setting the cost of borrowing money.
The Fed has two main objectives when it comes to the economy: stable prices and maximum employment. The Fed pursues those goals by raising or lowering interest rates.
When the Fed wants to bolster economic growth or recover from a recession, officials may move to lower interest rates. This action lowers the cost of borrowing money, which in turn incentivizes businesses to invest and hire more, and individuals to take out loans. Both cycle back into consumer spending.
On the flip side, when inflation is running above the Fed’s target rate of 2% of PCE, or the economy looks like it may be overheating, the Fed may choose to hike interest rates, which tends to lower demand by making loans more expensive, causing employers and consumers to rein in spending as the cost of borrowing money—and the rewards for saving or investing it—increase.
Interest rates are a blunt instrument, though, and for the Fed, deciding how far or how fast to swing them isn’t easy. The question—and big uncertainty—is just how much Fed action will be needed to bring inflation under control. Here’s the catch: the Fed must raise rates to slow demand enough to bring price increases under control. But raising rates too high or too quickly could cause the economy to tip into recession.
As officials begin lifting interest rates at the most aggressive pace in decades, here’s how you can expect the Fed’s interest rate actions to impact your wallet—and your banking decisions.
What is the federal funds target rate, and how does it work?
The federal funds target rate is the Fed’s main benchmark interest rate. It influences how much consumers pay to borrow money, and how much they’re paid to save.
Raising the federal funds target rate is one of the most powerful tools the Federal Reserve can employ to put the brakes on the economy, by making it more expensive to borrow money. This acts to reduce the supply of money in circulation, which tends to lower inflation as economic activity slows, giving time for America’s supply of goods and services—limited for more than a year by distribution snarls and labor shortages—to catch up to demand. This in turn lessens upward pressure on prices.
Which interest rates are impacted by the federal funds target rate?
Changes to the federal funds target rate directly influence the interest rates paid on CDs and savings accounts, and the rates consumers pay for auto loans, credit card debt, adjustable-rate mortgages (ARMs) and HELOCs.
If you already have a fixed rate mortgage on a home, a fixed rate home equity loan, or a federal student loan (most of which have fixed rates), interest rate fluctuations will not impact your monthly payment.
The Fed’s benchmark rate also influences other benchmark rates throughout the economy. They include the prime rate, which is the rate that banks charge their safest, most reliable borrowers. The prime rate tends to hold at about three percentage points above the fed funds rate, and also affects rates on credit cards, HELOCs, auto loans and other types of loans, such as small business or personal loans, you can get from a bank.
The stock market could be affected—but not in the way you might think
Fed rate increases have a pretty ambiguous impact on the stock market. On one hand, higher rates may incentivize some investors to sell assets and take profits, particularly in times like now, when there’ve been multiple years of double-digit percentage returns on stocks. But over the longer term, the data shows that in many cases, stock markets can rise when the Fed tightens monetary policy.
In its MarketWatch publication, the Dow Jones analyzed market data stretching back to 1989 to learn what history tells us about how stock markets react during rising interest rate cycles. That analysis revealed that during five long-term rate hike cycles, the three leading stock market indexes only declined during one cycle.
A (potentially) better savings yield
Higher interest rates are not all bad news. Where you park your cash matters, especially during times of increasing inflation. Online banks, community banks and credit unions typically offer higher yields than big banks. They may also be quicker to increase the interest rates they pay as competition between banks to win customer deposits increases.
With average savings accounts paying less than 1 percent, however, don’t expect a single interest rate hike (or nine) to make you rich overnight. According to the FDIC, the national average interest rate on savings accounts stands at 0.08% APY (as of June 21, 2022). Be aware, too, that banks may also not raise their yield on savings accounts immediately after a Federal Reserve rate hike, or at all.
Bottom Line
Boosting your credit score, paying off high-cost debt or refinancing into a lower rate loan can all create more breathing room in your budget in a rising-rate environment. All in all, this is a good time to make sure you understand the impact rising interest rates could have on your financial health, and on any new debt you plan to incur.
