The average consumer probably doesn’t scour the business pages whenever the Federal Reserve Bank meets to see what’s happening with the Fed Rate, but they should. Changes to the “Fed Rate” can cause significant changes to consumer savings and debt, and predictable increases can cause a balanced household budget to spiral out of control.
What is the Fed?
The “Fed,” in this context, refers to the Federal Reserve Bank. The Federal Reserve Bank is THE bank of the United States. Its actions are subject to congressional oversight, but its decisions do not require the approval of the President. The Fed’s policies influence monetary and credit conditions to optimize economic conditions including employment, pricing, and interest rates. It also regulates other banking institutions, and provides financial services to “depository institutions,” the U.S. government, and foreign official institutions.
Depository institutions are banks or savings associations that accept deposits. Most consumers receive a paycheck and deposit it in a bank, from which they can withdraw it later. The bank doesn’t keep the exact amount of everyone’s account in cash in the back. That would be unreasonable: Imagine the bank fees resulting from paying rent on vaults that size! The United States uses the fractional-reserve banking system, which means they keep a specially calculated percentage of total deposits on-hand for withdrawal.
If everyone who deposits their paychecks and savings into a bank were to withdraw their money at one time, for instance if people believed the bank was about to go bankrupt or lose their money, it causes a bank run or bank panic. This can result in the bank actually going bankrupt, and was a significant problem in the early twentieth century. (This phenomenon inspired an especially memorable scene in “It’s a Wonderful Life.”)
The Federal Reserve Bank mitigates this problem through regulation, policy, and as a lender of last resort. (The FDIC, or “Federal Deposit Insurance Corporation” assists by insuring deposits.) Essentially, the Federal Reserve Bank is where banks themselves, including the U.S. Treasury, keep their savings accounts and lines of credit.
What is the Fed Rate?
Consumer banking products have interest rates. For savings accounts, this is a small percentage of earnings, money that their deposit will earn and thus increase. For credit accounts this is a (not as small) percentage on their debt, money that the consumer pays for the privilege of receiving the loan. Banks saving or borrowing with the Fed have interest rates as well. This is the Federal Funds Target Rate, known as “the Fed rate” colloquially.
The Federal Reserve (actually governors and committee members) meet regularly and, among other agenda decisions, decide whether to set a new target rate or leave the current rate as is. This target rate influences how much banks can charge other banks when they loan each other money.
Recall that a bank must maintain a percentage of total deposits on hand for withdrawals. When that bank loans money, they no longer have that money in reserve. Some banks may have more deposits than loans, and thus have more money in reserve. This lending bank may cover the borrowing bank’s lack of reserves. This bank doesn’t do so out of the kindness of its heart: the lending bank charges the borrowing bank interest. Although the actual interest rate varies based on day-to-day market fluctuations, the federal funds target rate will influence how much the banks can charge each other.
What is Prime Rate?
Also recall that the bank that borrows from another bank does so to loan that money to a consumer, also not out of the kindness of its heart. The interest rate the bank will have to pay gets passed down, usually with another percentage tacked on for the bank’s trouble, to the end consumer. This is why consumer rates often fluctuate. Their rate is x percentage added to whatever the bank is paying, so if the percentage the bank pays changes, so does the rate passed on to the consumer.
Imagine the Fed sets the target rate at 0.25%, and a lending bank uses this rate to loan money to a borrowing bank. That bank then charges an extra 3% to the consumer. In many cases, however, the rate passed down to the consumer is even more variable, and changes depending on how risky the loan may be, or how risky the consumer borrowing money appears, based on their credit report. The bank may then choose to add a few more percentage points to the loan.
The Prime Rate serves as the basis for what a bank will charge a consumer. Depending on the risk of the loan, or the credit of the consumer, a bank may charge Prime plus some amount, but the starting point is usually Prime itself, and Prime starts with the Fed rate. Different banks may choose to set their own Prime rate, but many are based on the Wall Street Journal Prime Rate. This rate is based on averaging the rates of ten of the largest US banks as reported by market survey, and is published by the Wall Street Journal (WSJ).
The numbers used in the example above weren’t accidental. During the U.S. recession, the Fed maintained a target rate of 0.25% from 2009 to late 2015, and the WSJ Prime rate was a corresponding 3.25. In January of 2008, however, the Fed rate dropped 0.50% to 3.00%, with a Prime Rate decrease from 6.5% to 6.00%! This meant that loans in 2008 were twice as expensive in interest than loans with interest rates set in 2009.
What Happens When the “Fed Rate” Changes?
In some ways, interest rates are the blood pressure measurement of the economy. Doctors check blood pressure to indicate overall health. Too high indicates a need for rest, while too low may indicate a need for stimulation. When savings interest rates are high and credit rates are low, consumers flood money into the economy. This can be a good thing, if the job market and manufacturing sector can keep up with the increased demand for goods, or it can result in increased prices and inflation.
When saving rates pay very little, but credit comes at great cost, consumers are unable to make purchases, which restricts the manufacture of goods and impacts the job market, and are unable to pay back debts, which can result in loans, and the upstream payments that come as a result of those loans, to become insolvent.
The Federal Reserve Bank carefully monitors economic conditions and attempts to influence economic circulation by increasing or decreasing the Fed Rate to keep inflation at small, healthy levels and encourage a strong job market. (This is known as the Federal Reserve Bank’s “Dual Mandate.” They have many tasks, but these two objectives are the Fed’s primary focus.)
When the Fed increases or decreases the target rate, banks increase or decrease the rates at which they loan each other money, or make money by loaning to others and receiving interest payments. This influences the rates they pass down to the consumer.
Consumers who have savings products, such as a savings account or a money market account, will see their interest payments decrease when the fed rate decreases. More importantly, they will see their loan payments go up when the fed rate increases. Depending on the product, whether credit cards, mortgage payments, personal loans, auto loans, or student loans, these increases may take time to trickle down. For many consumers, they WON’T see their credit card payments go up, and will simply find more and more money going missing without suspecting the culprit: monthly finance charges.
What You Can Do to Protect Yourself
Given increases in economic disparity and increased reliance on debt, it is easy for today’s consumer to think these economic and financial mechanisms are for people with Real Money, imagining the early Rockefellers and Rich Uncle Pennybags from the Monopoly game. College students who can’t imagine ever owning a home assume these economic conditions only impact only homeowners. Working teens and young adults getting their first credit cards assume that only those with student loans need to care. However, ANYONE who borrows money will feel the effects of Fed rate changes, sooner or later.
Know Your Interest Rates and Indexes
An Index is something that indicates change or measures something. This could be a sample or key representatives of a type of market to show changes, such as increases in stock investments, or decreases in purchases of U.S. Treasury bonds. Savings and loan product interest rates are often tied to an index, meaning that when the index changes, the interest charged to the consumer changes proportionately.
The most common and simplest shift is usually in the Prime Rate, and many consumers will remember seeing fine print on credit card statements about Prime plus something, or perhaps mumbled section of car commercials. These products are usually variable, meaning that any shift in the economy that causes a change in Fed rate, and thus a change in Prime rate, will result in a change in the loan payment. These changes are calculated periodically, often daily or monthly. Variable rate student loans from private institutions are often based on Prime rate as well. Prime also influences the initial rate of a Fixed rate private student loan.
Student loans from the government use a different index, and are often less expensive than private loans. Student loans are based on the interest rate set for 10-year Treasury, which changes annually, and as a result the initial rate for a fixed loan won’t change as frequently as a private loan.
Mortgage interest rates use different interest rates and calculate interest differently. Adjustable rate mortgages usually only change rates a few times, often only once, over the life of the loan. Whatever the index is doing when the loan adjusts gets passed on to the consumer. Adjustable Rate Mortgages (ARMs) are names for their initial fixed period, and then how often they adjust. A 5/1 ARM is a loan that has 5 years at a stable interest rate, and then adjusts once on a specific day at the five-year mark. The index defined in the loan paperwork can cause two 5/1 ARMs that start on the same day at the same interest rate to have completely different interest rates when they adjust in five years.
If one loan uses an index that is more volatile, i.e., has drastic and rapid changes up and down, than the other loan, the amount of interest may be equally drastic in difference. Two common indices for ARMs include the London InterBank Offer Rate (LIBOR), which measures international bank lending rates, and the Constant Maturity Treasury (CMT), which measures Treasury products. These indices are further separated by the length of loan being measured. A 3-month LIBOR-based product measures index changes for very short term world market, and thus more likely to shift, loans. A 1-year CMT, in contrast, only adjusts once a year, and is based on a more stable U.S. product.
Make Informed Choices
While some consumers know that one of their credit cards charges 12% interest while another charges 21%, and makes purchasing decisions based on that, they may not know that a change in Prime rate can cause both of those cards to suddenly increase percentages. They may not realize that a Federal Reserve meeting that increases the Fed Rate by 1% means that possibly every debt they have, consisting of private student loans, auto loans, and credit cards just got more expensive as a result, and may have decreased what little savings they were counting on by paying even less in interest.
Those consumers fortunate enough to have scrounged together a down payment on a house may not be informed enough to accurately compare long-term lending products. One adjustable rate mortgage may seem initially attractive, but another product, only a fraction of a percentage point more expensive in the beginning, may be a better bet in the long run simply because of the index used to calculate future adjustments.
Consumers don’t need to become their own financial advisers or get a degree in economics to get a credit card, but reading about Fed Rate predictions and upcoming Federal Reserve meetings can save a lot money in the long run. Understanding how the Fed Rate influences day-to-day products, and making their purchasing and borrowing choices accordingly, can save consumers a lot of trouble and headache in the future.
Also published on Medium.