There have been three consecutive federal rate cuts from the Fed in 2019 so far. What does a drop in the federal funds rate mean for the average joe?
The Federal Open Market Committee (FOMC) meets regularly with the goal of discussing what decisions should be made regarding short-term interest rates, and their latest meeting was just last week before Halloween. This meeting occurs eight times a year, and typically results in an announcement about changes to the federal fund’s target rate, also know as the federal funds rate. The federal funds rate is a monetary policy tool that is used to achieve the Fed’s stated goals: price stability and low inflation, sustainable economic growth, moderating long-term interest rates, and promoting maximum employment. Whether the FOMC raises or lowers interest rates, a change to the federal funds rate can have an impact on every consumer in ways that may not be immediately apparent. What can be expected from a federal rate cut?
The Federal Funds Rate Has Seen its Ups and Downs
Historically, the federal funds rate has seen periodic hikes and cuts in response to varying economic factors. In 1980 and 1981, to counter inflation that resulted from Nixon’s move to remove the United States from the gold standard, it hit historic highs of nearly 20%. In contrast, After Obama’s fiscal policies began to take effect after the economic woes at the beginning of his first term, the Fed saw historically low rates.
From December of 2015 through December of 2018, there were nine consecutive rate increases announced, based on a variety of economic factors. Before October’s meeting, the FOMC – led by Fed Chairman Jerome Powell – made its first cut to the federal funds rate since the Great Recession in 2008, in late July of 2019. This cut, of 25 basis points, was quickly followed by a second rate cut in September of 2019 that lowered the federal funds rate by an additional 25 basis points. Note: A basis point is a unit used to represent a portion of a percentage point when discussing the federal funds rate. 100 basis points are equal to 1 percent, so a change of 25 basis points equals a reduction or increase of 0.25% to the rate in question. In October, after much speculation, a third rate cut was announced, leaving the federal funds target rate at a historic low. Currently sitting at 1.50-1.75% as of this writing, the federal fund’s target rate is a guideline for the actual rate that banks charge each other on overnight reserve loans; the rate that a lending bank charges does not have to be the exact rate set by the fed, and is determined through negotiations between the two banks. The FOMC influences this transaction by setting the target rate as a guideline, and as such the Fed’s target rate is essentially the basis for bank-to-bank lending.
Why Does the Fed Lower Interest Rates?
There are several reasons for lowering federal interest rates, and the decision to hike the federal funds rate or cut it is not made lightly. The market is typically a volatile place – speculation alone can lead to changes as the stock market trades, for example. Trade tensions between the U.S. and China have also led to significant changes, along with speculation of an impending recession, like the recession of 2008. In order to stave off this sort of economic depression, the Fed acts by cutting the federal funds rate. When the Fed lowers these rates, it can encourage borrowing and investing; lower financing costs often stimulate economic growth. In an economy with low rates, businesses and companies can borrow money more cheaply, which in turn allows them to grow their businesses at a faster rate, boosting the economy further. On the other hand, when rates are too low, this can encourage excessive growth which leads to inflation, undermining the sustainability of economic expansion by reducing purchasing power. There is always uneasiness about the economic outlook – both domestic and global. This uneasiness is a big factor when it comes to when, how, and why the federal funds rate is raised or lowered.
How Does a Rate Cut Affect Consumers?
A drop in the federal funds rate can have a ripple effect; there will be short-term changes, as well as long-term effects. Typically, a cut to this rate would affect the following:
Credit Card Rates
The majority of credit cards have variable interest rates, which are tied to the rate that banks charge to their customers with good credit, known as the prime rate. The prime rate, in turn, is based on the federal funds rate – so when the Fed raises or lowers its benchmark interest rate, the prime rate follows accordingly – and a credit card with a variable rate would see interest rates follow suit. A fixed-rate credit card would see no changes due to a cut from the Fed; however, the credit issuer can still change the interest rate at their discretion, provided they give advanced notice. What Does This Mean? Whatever the Federal Reserve does in regards to its benchmark rate directly affects short-term interest rates, which is reflected in the rates that people pay on credit cards.
As with credit cards, the impact that a rate cut can have on home financing depends on the type of mortgage a consumer has: fixed-rate, or adjustable-rate. A fixed-rate mortgage does not fluctuate with short-term rates; most adjustable-rate mortgages are linked to short-term Treasury yields which move with the Fed, or to the London Interbank Offered Rate, which does not follow the Fed precisely and can move independently of the Fed. What Does This Mean? A rate cut will not impact the amount of the monthly payment of a fixed-rate mortgage since fixed-rate mortgages do not move directly with the Fed’s rates. A rate cut by the Fed changes the short-term lending rate; most fixed-rate mortgages are based on long-term rates and as such are not affected. In other words, mortgage rates are not likely to show a quick response to an adjustment to the Fed. Alternatively, adjustable-rate mortgage payments often see a decrease when the Fed has issued a rate cut.
We know that the Fed’s target rate is used as the basis for bank-to-bank lending – but what about lending for consumers? Banks charge their most creditworthy customers a specific rate that is usually pegged at 300 basis points (3%) above the Fed’s target rate, known as the prime rate (as mentioned above). A consumer who has taken out a loan, or opened a credit line, can expect to pay interest at a rate reflected by the prime rate plus a premium. The total premium a consumer will pay depends on a variety of factors that the bank uses to determine this rate, based on the consumer’s assets, liabilities (existing debt, for example), creditworthiness, and income. What Does This Mean? Since the rate at which banks lend to consumers, the prime rate, is tied directly to the Fed’s target rate it stands to reason that a cut to the Federal funds rate would be reflected by a reduction to consumer interest payments on financing that is linked to prime. This could help consumers save money since they would have lower interest payments.
Savings and CD Rates
When the Fed cuts interest rates, banks typically lower the annual percentage yields (APYs) that are offered on their consumer products, including savings accounts and certificates of deposit (CDs). When it comes to savings, there are broad conditions that can dictate what moves each bank makes – in June of 2019, banks chose to lower their yields in anticipation of a rate cut, for example. Broader economic conditions affect CDs as well, including the 10-year Treasury yield. What Does This Mean? If you are looking to your high-yield savings account after a cut to the federal funds rate, you may not see any benefits because banks typically lower the APY they offer in tangent with the Fed’s interest rates. This doesn’t mean disaster, if you notice your yields rates have dropped – odds are, your annual returns will still outpace inflation, particularly if you have a high-yield savings account. When it comes to CD yields, these typically fall when the Fed cuts rates as well. If you are looking for a certificate of deposit and are worried about this latest rate cut impacting your annual returns, it’s a good idea to lock down a CD rate now, if you find one with a competitive rate that suits your financial goals.
Auto Loan Rates
The Fed, for lack of a better word, drives auto loan rates; even though the federal funds rate is a short-term rate and auto loan terms are more long-term, auto loans are still affected by the prime rate, which in turn is tied directly to the Fed. What Does This Mean? If you’re in the market to purchase a new car, you might notice slight relief on your auto loan rate after the Fed cuts the federal funds rate. This impact will be modest, however – usually it is less than 100 basis points, on average.
After a rate cut from the Fed, it’s easy to fall into the mindset that lower interest rates discourage savings since there is a lower yield when these interest rates fall. Essentially, these cuts are meant to incentivize borrowing and spending, to get money out of peoples’ bank accounts and into the economy; basically, it reduces the cost of money. That does not mean that the average consumer should not build their savings after a rate cut; there is never a “bad time” to save, and building an emergency savings cushion – as well as saving your money, be it for purchase or retirement – is a responsible financial step. The federal funds target rate is used as a monetary policy tool; changes to the target rate affect consumers in a variety of ways, and its effects particularly differ between consumers who borrow and consumers who save. A good rule of thumb: If the Fed cuts interest rates, it helps consumers who are borrowing money – and the impact will depend on the type of loan and interest rates (fixed or variable) that are in play; folks who are more interested in savings will not see significant benefits.