How does a Federal Reserve rate increase/decrease affect you?
With the latest announcement by the Federal Reserve about lowering the Federal Funds Rate I thought it would be a good time to discuss what that means. The Federal Funds Rate is the amount that banks charge each other to hold funds overnight. In a nutshell, banks have to keep a certain level of deposits on hand to meet reserve requirements. This is to make sure that they cannot lend every dollar they have and then not have enough money on hand to conduct business the next day.
When a bank has excess cash levels on their books the best way to maximize that cash is to lend it out to another bank for a set period of time. This is a way to get a steady stream of income for idle cash. Now, you are probably saying to yourself,"Why don't they just lend it out to people?" Good question. There are many factors that could answer that question but the easiest one is they may not be able to. They could be in an area that has an older population with a lot of deposits but not necessarily a high rate of borrowing.
We all know the "high" rate of interest we are earning on our savings accounts, right? Well even though it is minimal, the banks still need to cover those costs. This is where the lending of funds to other banks comes in. This is the safest way for the bank to invest the cash without having to worry about not getting repaid. In the old days of Saving and Loan Banks the bank could only lend out the same amount of money they had in the safe. Once regulations were removed, this allowed banks to lend more than they had on deposit (other banks money).
Now that you know what the Federal Funds Rate is we can explain how if affects you. When the reserve raises or lowers this rate it makes the borrowing costs of those other banks fluctuate. If they raise the rate by .25% the receiving bank must pay .25% more to borrow money. For the last few years, the rate for banks to borrow money was at 0%. This is why savings rates remained very low. The bank could borrow other peoples money cheaper than paying you for keeping yours in the bank.
Most short term interest rates are tied to Prime interest rate. This rate is the average rate that all banks would charge their best customer. The reserve will survey banks to obtain this rate periodically. If you look at most of the credit card statements it will indicate a Margin + Prime. Every time prime changes, so does your credit card rate.
The real world example is that if you have a home equity line of credit it is typically tied to the Prime Interest Rate. The current Prime rate is 5.50%. The banks usually adjust rates at the beginning of the month after the change. Theoretically, August 1st Prime rate will be 5.25%. This will affect you if you have a variable rate because you will pay less interest.
You are probably sitting there saying, "Great! I will have to pay less", which is true. However, this also means that the reserve believes that the economy is beginning to show signs of a slowdown, which if true, is not a good thing. In the end, this change may or may not affect you directly but it almost certainly will have an effect on you someway.
When interest rates increase or decrease it makes the cost of production of goods follow closely. Even if you have no debt you will still be impacted by these changes. Your clothes, shoes, gas, groceries, and even haircut will be directly affected by these changes because the businesses borrowing costs change and will need to be passed onto the customer.
Thank you for taking the time to read my blogs. I am in no way a subject expert and these are simply my opinions. I welcome any thoughts and discussion.
