Recently, everyone from Wall Street to Main Street has focused on what the Federal Reserve (a.k.a. “the Fed”) will do with interest rates. You may be asking yourself, what will the Federal Reserve’s decision to raise interest rates really mean? How will it affect me, the everyday consumer? In spite of all the media hype, you may be surprised to learn that it means very little for consumers.
To understand the Federal Reserve’s power and its effect on the everyday consumer, you need to have a good idea of the Federal Reserve’s responsibilities. Created in December of 1913, the Federal Reserve regulates, supervises, and maintains stability of the nation’s monetary system. The key word in the Federal Reserve’s job description is “influence.” This legal term was included in the Federal Reserve Act, which created the Federal Reserve, and was signed by President Woodrow Wilson.
The Federal Reserve can influence the nation’s financial system through several different financial tools. They can increase or decrease the money supply to banks – making it harder or easier for them to loan money. The Federal Reserve can also increase or decrease the “federal funds rate.”
The federal funds rate is what the media has focused their financial reporting on. The Federal Reserve regulates banks. Banks are required to hold a certain amount of reserve cash. The Federal Reserve holds these reserves and, if another bank needs extra cash to make their required reserve amount, other banks with extra “reserve” can “lend” them the money at the federal funds rate.
The reason many people are fixated on the federal funds rate is because, in general, a higher interest rate for the banks to borrow money means a higher interest rate for consumers to borrow. Currently, the federal funds rate is set between 0-0.25%. This means that banks can borrow to cover their reserves at near 0% interest rates. In turn, banks loan money to the consumer at low interest rates.
According to Bankrate.com, the current average 30-year fixed mortgage for the Washington D.C. area is 4.0%. On June 29th 2006, the federal funds rate was 5.25% and the average 30-year fixed rate mortgage was 6.71%. While the difference between lending rates and the federal funds rate is not a perfect ratio, the main point is that, when the federal funds rate increases, interest rates for consumer borrowing may also increase.
Even though consumer interest rates generally increase with a federal funds increase, the actual near term increase means very little. This is because regulators are very cautious on how they go about changing such an important figure. If and when the federal funds rate increases it will be done in a very small amount. Since 1991, the Federal Reserve has never raised the federal funds rate more than .50% at any one time and about 80% of the time the rate has only moved .25% when the Federal Reserve changed the rate. In August 2004, the 30-year fixed rate mortgage was 5.85%. When the Federal Reserve raised the federal funds rate by a quarter of a percent in September 2004 – from 1.50% to 1.75% – the average 30-year fixed rate actually went down to 5.75% and stayed down the rest of the year.
As you can see, the near-term change in the federal funds rate can mean very little to consumers. However, the media will cover the Federal Reserve’s decision to raise the federal funds rate like a large natural disaster. The main point is to not get caught up in the perceived panic and understand that an increase in rates means the government is confident in the nation’s economy.
Continue to save! Continue to review and refine your financial plan. A .25% increase in the federal funds rate will have very little impact on your ability to borrow or make loan payments. Stay focused on your financial course.
Jonathon Rowles Captain, USMC (Ret.)
Disclaimer: (have to do it) – This blog should not be considered financial, investment, legal or tax advice. Consult your licensed financial professional, tax advisor or legal counsel. This blog is for educational purposes only.