Last Wednesday, the Federal Open Market Committee—the policymaking body of the Federal Reserve—increased the target federal funds rate by a quarter of a percent (to a target of 1.25%). While that's a decision that occurs at the very highest levels of U.S. monetary policy, few executive decisions affect the wealth and daily life like the Fed rate hike.
That's because the federal funds rate is the single most influential interest rate in the country—and perhaps the world. The federal funds rate directly influences the prime rate, which is the base rate banks charge to loan money to their most trustworthy credit clients. The higher the prime rate, the more expensive it is for customers to borrow money from the bank.
Moreover, the federal funds target rate (which is technically what the Fed has decided on) serves as a forecast of how strong the economy will be over the next few years. During the Reagan administration, the federal funds rate was at an all-time high of 20 percent—during the 2008 recession, it was brought to zero (and stayed there until recent years).
What Is the Federal Funds Rate?
The federal funds rate begins with knowing how banks interact with the Fed:
Every bank is required by the Federal Reserve to maintain a certain ratio between money in their reserves and the money they loan out. In other words, they need to have a certain amount of cash "on hand" (or in their account at the Federal Reserve) at the end of every day, and that amount depends on how much money they loan out. This prevents banks from loaning out too much money and overextending themselves.
(If you remember the film "It's a Wonderful Life," this is what happened when the town of Bedford Falls came to George Bailey demanding all of their money at once. The bank simply didn't have enough on hand to satisfy all the withdrawals—having a federally-mandated reserve prevents this from happening).
Now, it's fairly often that some banks will not have enough money in their reserve to meet the ratio, and other banks will have more than they need. The banks with a surplus can then lend their excess reserves to another bank with a deficit, charging them a small percentage for the loan.
That percentage is the federal funds rate—in the simplest terms, the federal funds rate is the cost of borrowing money from one bank to another. When it's more expensive for banks to borrow from each other at the Fed, they make it more expensive for consumers and businesses to borrow money as well—essentially making it more costly to raise capital or use credit. This raises the strength of the dollar (ideally), which helps reduce inflation and increase wages.
So How Does This Affect Me?
Like we mentioned, raising the federal funds rate also raises the prime rate, which is the base rate at which banks lend money to consumers and businesses. The prime rate is the base for every credit card, savings account, and variable-rate loan. As a result, borrowers will find that borrowing is more expensive—while people who save will find that their savings accounts will be more valuable.
Here are the general effects that consumers should expect:
- Credit rates will climb, making it more expensive to spend
- Mortgage rates may climb as an indirect effect (not always)
- Variable-rate mortgages will rise in cost
- Savings account rates will rise
In times where the federal fund rate is higher, it's the Fed indirectly encouraging the nation to save instead of spend. As the Fed raises the federal funds rate, it'll be even more beneficial to save your money and take advantage of the rising interest rates by investing rather than using credit.
What won't be affected:
- Fixed-rate loans
- Most mortgages
- Student loan debt
- Auto loan rates
The Good News
The Federal Open Market Committee makes policy decisions based their forecast of the nation's economy. When the economy is accelerating too fast and increasing inflation, they'll employ a high rate to slow it down a bit. When the economy is sluggish and the Fed wants to encourage spending, they'll lower the interest rate. By employing a raised-rate policy, they're telling us that they expect the economy to accelerate in the coming years.
As always, if you're recovering from a bankruptcy and you're looking to rebuild your credit, it'll be vital to be cautious with your spending in the near future. Thankfully, the Fed's current policies align with your personal financial goals pretty well—cautious, controlled spending, more saving, and conservative use of credit.
However, rising interest rates meaning having outstanding debt will be even more detrimental to your wealth. If you're looking for a way to start fresh, consider calling a bankruptcy attorney—they can explain your options and determine if filing for bankruptcy is the smart move (before the Fed raises the federal funds rate even more!).