June 22, 2016 | by James Behr Jr
On June 15th, the U.S. Federal Reserve, commonly referred to as the Fed, made the decision to maintain the federal funds rate of 0.25-0.50%. The Fed cited slow economic growth, low inflation rates, a possible British exit from the European Union (“Brexit”), and a high unemployment report for May. The Federal Reserve has been in the news often and the following is a brief background of the Fed and how rising rates may affect you.
What is the Federal Reserve?
The Federal Reserve is the U.S. central banking system that decides the nation’s monetary policy by managing the U.S. currency, money supply, and interest rates. The main objective of the Fed is to ensure the stability of the U.S. financial system. The Federal Reserve Board of Governors convenes every six weeks to make decisions that affect you, millions of other Americans, and the global economy based on various economic data and current world events.
The Federal Reserve can affect monetary policy and economic growth in three separate ways. First, it establishes the discount rate which is the rate that banks borrow from regional Federal Reserve Banks. A higher discount rate tends to discourage banks from borrowing which in turn reduces lending to consumers. Secondly, the Fed buys and sells U.S. Treasuries in the market in order to influence interest rates for consumers. When the Fed buys U.S. Treasuries and increases the price of the bonds, the yields go down and consumer interest rates will follow. Lastly, the Fed sets the reserve requirement which is the amount of capital banks need to hold and when the reserve requirement is higher, banks are less likely to lend money.
Since 2008, the federal funds rate has been at historic lows as the economy recovers from the Great Recession. The majority of bank saving accounts rates are below 1% which, in economic theory, encourages people to take their money out of the bank and invest it into the economy, in pursuit of a higher rate of return.
How can the Fed affect you?
The most well-known way the Fed affects consumers is typically the interest rate on home mortgages. Mortgage rates closely follow the yield of the 10-year U.S. Treasury bonds and if the Fed decides to change the discount rate or federal funds target rate up or down, it can have a large effect on lending for homes.
The federal funds target rate is also an important factor in setting auto loan rates, home equity lines of credit, credit card rates, and yields on Certificates of Deposit (CD). Auto loan interest rates, home equity lines of credit, and credit card interest rates usually move in tandem with the prime rate, which is set by the 10 largest U.S. banks. The Fed is able to affect the prime rate by buying and selling short-term U.S. Treasuries, thus affecting interest rates. CD yields typically move in line with the federal funds target rate and any increase in the target rate should cause CD rates to rise as well.
Any change in monetary policy can also indirectly affect inflation/deflation and the job market. An increase in the money supply encourages consumers to spend and can make it easy for businesses to raise prices on goods and services also known as inflation. The Fed’s actions on interest rates also make it more or less advantageous for businesses to borrow money which indirectly could lead to companies hiring more employees or not.
The actions of the Federal Reserve are a major topic not only in the U.S. media but globally. The decisions that the Fed may make in the coming months to either raise rates or continue to keep them low will have an impact on financial markets. Lower interest rates will benefit those that are younger and may be borrowing money as it is cheaper to do so. If you are at a point in life where you are depending on your savings and income, lower rates are not as beneficial.
Whichever of these two groups you fit in, our team at Blue Bell Private Wealth Management will be able to help you with your financial future. Although each Federal Reserve decision may move markets in the short term, we always believe that staying invested for the long term is more important. If you would like to learn more about how we can help you grow and protect your savings and investments please email us or contact us at (610) 825-3540.