The Federal Open Market Committee (FOMC) uses monetary policy tools such as the fed funds rate to achieve its goals of maximum employment and stable prices in the economy. With inflation surging, the FOMC is expected to continue raising rates for the rest of the year.
When the FOMC meets, it sets a target range for the fed funds rate. It can't force banks to use this target, but the entire financial system typically follows the fed funds rate as a guidepost for setting interest rates.
Read more about the most recent Federal Open Market Committee meeting and changes to the fed funds rate here.
The fed funds rate affects all other interest rates. It directly affects rates for savings accounts, certificates of deposit (CDs), and money market accounts. Banks also use it to guide short-term interest rates. These include auto loans, credit cards, and home equity lines of credit. It also includes adjustable-rate loans.
The Fed's rate decision indirectly affects long-term rates as well, such as fixed-rate mortgages and student loans. It's one of the most critical factors in determining interest rates.
The Effect on Everyday Life
The demand for products and services increases when consumers have more money. That can happen when they can borrow money at reasonable rates. Think of a pricey new car you want and the auto loan you'd be able to take out when rates are low. But there's a flip side. As rates rise, that car might be less pricey as inflation comes down but the loan costs will rise. An increase in the Fed's rate tends to keep prices more stable.
The opposite occurs when rates are high. The real estate market softened in 2019 as higher mortgage rates made home loans more expensive. But mortgage rates plummeted during the pandemic in 2020, opening up new opportunities for homebuyers.
The economy becomes sluggish when the federal funds rate is high. As a result, companies cut back on hiring. Employees become trapped at the pay rate they're currently receiving because raises and incentives are likewise curtailed. But the Fed believes that curbing inflation is worth it.
Savings Accounts, CDs, and Money Markets
Banks used to base interest rates for fixed income accounts on the London Interbank Offered Rate (LIBOR). However, not for much longer. LIBOR rates ceased being published at the end of 2021, and USD LIBOR will be replaced as a reference rate by mid-2023. The Alternative Reference Rates Committee has identified the Secured Overnight Financing Rate (SOFR) as the preferred replacement rate.
Fixed income accounts include savings accounts, money market funds, and CDs. Most of these follow the one-month LIBOR. Longer-term CDs follow longer-term LIBOR rates.
The rates in the LIBOR history compared to the fed funds rate might show that they trend along a similar path, but this hasn't always been the case, particularly in 2008 and 2009 when the two diverged during the recession.
Credit Card Rates
Banks base credit card rates on the prime rate. It's typically three points higher than the fed funds rate.
The prime rate is what banks charge their best customers for short-term loans. Your credit card interest rate could be eight to 17 points higher than the prime rate. It depends on the type of card you have and your credit score. The Consumer Financial Protection Bureau protects consumers’ finances by regulating credit, debit, and prepaid cards.
The fed funds rate directly guides adjustable rate loans. These include home equity lines of credit and any variable rate loans.
Auto and Short-Term Loans
The Fed's rate hikes indirectly affect the fixed interest rates on three-to-five-year loans because banks don't always base these on the prime rate, LIBOR, or the fed funds rate. They can also base them on Treasury bill yields.
Yields are the total return investors receive for holding Treasurys. The rate you pay could be several points higher than a Treasury note of the same duration.
Treasury Bill Yields
The fed funds rate is one of the factors affecting Treasury bill yields. The U.S. Treasury Department sells them at an auction. The higher the demand, the lower the interest rate the government must pay. Their interest rates depend on investors' sentiment.
For example, investors demand more Treasurys when there are global economic crises. Treasurys are ultra-safe because the U.S. government guarantees repayment. As the economy improves, there will be less demand. Thus, the government will have to pay a higher interest rate. The Treasury has lots of supply because the U.S. debt exceeded $30.4 trillion in April 2022.
The Impact of Forex Traders
Another factor is the demand for the dollar from foreign exchange (forex) traders. When demand rises, so does the demand for Treasurys. Many foreign governments hold Treasurys as a way of investing in the U.S. dollar. They buy them on the secondary market. There is a higher demand for Treasurys when the demand for the dollar strengthens. That sends the prices up, but yields down.
Yields on treasury bills could fall if there's a high demand for the dollar and Treasurys. This could offset any increase from the Fed's rate hikes if the demand were high enough, but that's unlikely. As the economy improves, the demand for Treasurys falls. As a result, interest rates on auto and other short-term loans rise along with the fed funds rate.
Mortgage Rates, Home Equity Loans, and Student Loans
Banks also base the rates for fixed-interest loans on the federal funds rate. Three- and five-year auto loans are based on the five-year Treasury note. The banks base interest rates for 15-year mortgages on the benchmark 10-year Treasury note. The rate for a 15-year fixed-rate mortgage is about a point higher than for a Treasury.
Home equity lines of credit (HELOC) are also tied to the prime rate, so you can expect these rates to increase as well and this can be difficult because they're usually variable. You could be hit with increased payments seemingly out of the blue with anticipated rate hikes coming periodically, making it difficult to budget. These rates still might be lower than credit card rates, however, making a HELOC worth considering if you're taking one out to pay off a credit card or other debt with a still higher rate—as long as you keep in mind that what you're paying today might not be what you'll pay tomorrow. Otherwise, you might want to avoid this type of loan for now.
Again, that extra is so the bank can make a profit and cover costs. As a result, bonds directly affect mortgage interest rates.
How Do Bonds Affect the Economy?
You might own bonds as part of your IRA or 401(k). Bonds are loans made to corporations and governments. If you own a bond, you make money from the interest rate paid on it. That amount is fixed for the life of the bond.
As the fed funds rate rises, interest rates on other bonds will rise to remain competitive. Bonds will become a better investment in the future. But if you resell your bond, it will decline in value until the price falls and the return at the new price level is equivalent to the current interest rate.
Bonds determine the ease or difficulty of getting credit, and these affect economic liquidity and purchasing abilities.
It's more likely that you own bond mutual funds. Higher interest rates don't help bond funds. The Fed only raises rates when the economy is doing well. In that case, most investors buy more stocks. That makes bonds less attractive and depresses the value of bond funds.
Because bonds compete for investors’ money, bonds affect the stock market by being the alternative, less volatile investment instruments.
Seven Steps to Take Now
- Pay off any outstanding credit card debt. Your interest rate will go up as the Fed raises rates.
- Feel better about saving. You'll earn more. But don't lock into a three- or five-year CD. You'll miss out on the higher returns when the Fed raises rates again.
- Shop around to take advantage of the best rates on your savings accounts. Big banks raise their rates more slowly than smaller ones.
- Online banks have the best rates of all. They can be more competitive because their costs are lower. That allows them to have fewer fees. They have online chats and mobile apps to manage your account. Many also provide online tools.
- Don't procrastinate if you need to buy appliances, furniture, or even a new car. Interest rates on those loans are going up. They will likely get higher over the next several years. The same is true if you need to refinance or buy a new house. Interest rates on adjustable rate mortgages are going up now. They'll continue to do so over the next three years, so question your banker about what happens when the interest rates reset. They will be at a much higher level in three to five years. You might be better off with a fixed rate mortgage. In fact, now might be the best time to get a mortgage.
- Talk to your financial adviser about reducing the number of bond funds you have. You should always have some bonds to keep a diversified portfolio. They're a good hedge against an economic crisis. But this isn't the right time to add a lot of bond funds. Stocks are a better investment as the Fed continues to raise rates.
- Pay close attention to the announcements of the Federal Open Market Committee (FOMC). That's the Federal Reserve committee that raises interest rates. The FOMC meets eight times a year. These meetings show how the Fed raises rates through its open market operations and other monetary tools.
The Bottom Line
Small rate boosts, like the quarter-point increases seen between 2015 and 2019 and forecasted for 2022, have gentle effects on the economy. The Fed does a good job of signaling its moves. As a result, the markets aren't surprised by its actions.
The impact on you is more immediate. Banks raise the prime rate on loans the next day. Adjustments to your credit card rate might not appear until the next billing cycle or even in the next quarter. If you hold a fixed-rate mortgage, it won't affect you at all.
Even for variable-rate loans, a quarter-point increase won't have a radical impact. Of course, that depends on the size of your loan and monthly payment. It can add up on a substantial loan, especially if the Fed raises rates several times a year.