On March 15, the Federal Reserve Bank of the U.S. voted to increase its key interest rate for the second time in three months, and only the third time since the 2008 financial crisis. CNBC and other outlets reported that the key rate, which determines interest paid from consumer banks for the cost of loans from the Fed, would rise to at least 0.75 percent and as high as 1 percent. While most financial professionals and economists anticipated this decision, the event remains an important one each time it occurs, as the Fed is the chief dictator for the monetary policy of the U.S. and, in turn, many institutions around the world.
But ordinary Americans would be forgiven if news of the rate hike passed them by. After all, the Fed's responsibilities and actions can be confusing even to seasoned financial veterans, and it's even more difficult to understand how they will impact consumers. Fortunately, the Fed's actions aren't something too many of us need to worry about on a daily basis, but it does help to understand the basics.
What does the Fed do?
In a nutshell, the Federal Reserve is the government agency in charge of establishing the monetary policy of the United States. As Yahoo Finance explained, this means the Fed keeps the nation's private banks in check, and keeps an eye on broader economic trends to determine the best course of action. The Fed's ultimate goal is to keep the nation's economy growing at a steady rate. This means achieving a balance between many factors including employment, inflation and other aspects of the economy.
"The Federal Reserve controls U.S. monetary policy."
The primary way the Fed accomplishes this economic balancing act is by manipulating the target funds rate. This is the rate at which the Fed loans money to banks, which they then use to provide financial services to consumers. In times of weak economic growth, like what's been seen in the last several years, the Fed will loan banks money with almost no interest. This encourages banks to issue inexpensive loans, which can help get consumers back on their feet after having lost a job, for example. When the Fed's interest rates are low, so is the interest rate attached to consumer loans like mortgages and credit cards. At the same time, consumers don't stand to earn much from savings accounts.
On the other hand, sometimes the economy can grow too quickly. When the Fed issues cheap loans to banks, inflation can rise, which means the cost of goods and services becomes too much for consumers to handle. To prevent this, the Fed will raise interest rates. This makes consumer loans more expensive, but also makes passive savings more advantageous.
How does the Fed impact consumers?
Since the Fed's interest rate decisions are designed to make it easier or harder for banks to extend credit, they have the effect of making consumer loans and other financial products more expensive for everyone. Here are a few ways the Fed's interest rates can be felt by ordinary Americans:
Mortgages get pricier
The majority of U.S. homebuyers take out a mortgage to finance the purchase, typically with a fixed rate designed to be paid off in 30 years. When Fed rates go up, you can generally expect mortgage interest rates to rise as well. But since home loans last for decades, banks need to price in the likelihood of future interest rate hikes before they actually happen. That's why, looking at historic interest rate data from Freddie Mac, it's easy to see that banks generally anticipated the last two rate increases, but have kept mortgage rates steady or even lower in recent months, perhaps because they don't see another rate hike coming so soon.
Higher mortgage interest rates are supposed to make homes a little harder to purchase, but this is ideally offset by strong employment and rising wages, both of which the U.S. economy can currently boast. Also, home loan rates remain very low compared to almost any year prior to 2007, proving it's still a good time to be a homebuyer in America.
Credit cards and other loans
The credit cards you keep in your wallet can be considered another type of loan, since it allows you to buy something now and pay for it later. The interest rate charged by card companies, like mortgage rates, also tends to change with the Fed's actions and the fluctuations of the general market. But credit card rates are more often variable instead of fixed like many mortgages. They are also much higher - a card with 15 percent interest would be considered low compared to most. While these rates may only increase by 1 percent or less per year, that can equate to much more money for those who carry a high amount of debt on their cards.
Other types of loans, including student loans, may also change with the Fed's rate-hike decisions. According to The New York Times, the interest rate on federal student loans is tied to the 10-year Treasury rate, which is influenced by the Fed's policies. Most economists expect student loan rates to begin rising over the next several years, but they will remain relatively low compared to ordinary consumer debt. Borrowers who have already begun paying off their federal loans do not need to worry about these rising rates.
The Fed chooses to raise its interest rates when the economy is doing well, and when this is true, it generally means the price of goods and services is rising due to inflation. The Fed wants to keep some level of inflation - 2 percent per year is its ideal target - and that means the cost of living will also slowly rise for everyone. But with wages also increasing at an even faster rate, the effects of inflation should be mostly negated.
It's never wise to bet on where the financial markets are headed, but it helps to understand the basic principles behind their behavior. Visit your local Landmark Bank for more information on how you should react to financial changes.
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