Why is the Fed Interest Rate So Important?

Today the Federal Reserve (aka the central bank, or the Fed) raised its interest rate, known as the Fed Funds rate, by another 0.5%, up to 4.5%. There's been a lot of talk this year over the Fed raising interest rates in an effort to fight inflation. What is the Fed Funds rate and why does it matter so much?

The Fed Funds Rate is the interest rate that the central bank sets for banks to charge each other for borrowing and lending cash between each other. Essentially, it's the cost the banks pay to borrow money from other banks. Banks and other financial institutions are required to maintain a certain amount of money on reserve to cover depositors' withdrawals and other obligations. When necessary, banks and other financial institutions will borrow money from a Federal Reserve bank, and they are charged the Fed Funds interest rate for borrowing.

The Fed Funds rate influences what is called the prime lending rate. You may have seen a bank refer to the prime rate when you've applied for a loan. For example, the bank will charge an interest rate that is the prime rate plus a certain percentage. The prime rate is the interest rate banks charge their most creditworthy borrowers, which are usually very high net worth individuals, businesses, and other financial institutions.

Since the Fed Funds rate affects the prime rate that banks use, it then has an effect on the rate individuals are able to borrow at for things like mortgages, auto loans, and credit cards. As the Fed Funds rate increases, the banks' interest rates increase, and thus the interest rate they charge borrowers for things like homes and cars goes up. It isn't always a change in the rate by the same amount. Banks try to forecast what they think the rate will be later down the line and what the cost of the money for them will be, and then they charge accordingly. That is why sometimes you'll see an increase or a decrease in mortgage rates when the Fed hasn't made any changes to their target interest rate.

The Fed Funds rate also has an effect on short term interest rates. These are interest rates the bank pays for savings accounts, money market accounts, CDs, and more. It also affects the rate for short term bonds, such as Treasury Bills. For interest rates on savings accounts and CDs you'll generally see the rate the bank offers is lower than the Fed Funds rate. That is because the bank will try to lower their expenses by using depositor funds at a lower rate than the rate they would need to borrow from other banks. For example, before the Fed raised rates earlier today, the Fed Funds rate was up to 4%, but most high-yield savings accounts paid depositors an interest rate of 3%. The bank can pay you 3%, and then loan money out at 4% (or more, depending on who it's being loaned to).

Last year, as inflation was really starting to rear its head, the following Escient Financial Insights articles were posted. They are a recommended read if you'd like more insight into inflation and what it does.

• Is Inflation Haunting Your Financial Dreams?, Part 1: What We Know
• Is Inflation Haunting Your Financial Dreams?, Part 2: What We Can Do About It
• Understanding Inflation in 2021: What Investors Need to Know

The basic concept of inflation is that it is the rate at which a currency loses its purchasing power as prices increase over time. Inflation can be caused by a number of factors. In the current case of high inflation, the cause was more than one factor. Here are the most prominent causes:

• An increase in the money supply. At the end of 2019, the M2 money supply (which includes financial assets held mainly by households such as savings deposits, time deposits, and balances in retail money market mutual funds, in addition to more readily-available liquid financial assets as defined by the M1 measure of money, such as currency, traveler's checks, demand deposits, and other checkable deposits)¹ was approximately $15.32 trillion. At its height during the COVID-19 pandemic, the money supply had reached up to approximately $21.74 trillion, a nearly 42% increase in only 2 years.² The M2 money supply has been decreasing as the Fed has implemented quantitative tightening (QE), where it is reducing bonds held on its balance sheet, which pulls money out of circulation. The M2 money supply is approximately $21.4 trillion as of October 31, 2022.
• Economic stimulus checks sent to taxpayers during the COVID-19 pandemic, whether individuals needed the assistance or not.
• Supply chain constraints caused by the COVID-19 pandemic.
• Low interest rates.
• The war in Ukraine caused a supply shortage in energy supply and food.

During the COVID-19 pandemic, the U.S. government, along with other governments in nations around the world, stimulated their economies by dropping interest rates and sending stimulus checks to taxpayers. Central banks also injected trillions of dollars into the global economy by buying up bonds and other debt. Doing so put money, and even more cheaply borrowed money, in the pockets and bank accounts of individuals and businesses. Those actions did keep employment up and kept people spending, so the economy kept going. Stock markets roared to new all-time highs and economic growth surged. Demand was high. Eventually, though, the supply couldn't hold up. There were shortages of an array of goods from wheat to microchips, and that caused prices to soar. Thus, inflation.

You may be wondering how inflation comes into play with the Fed Funds rate. A large part of how the economy grows, and the pricing of goods, has to do with liquidity. Liquidity is the availability of cash to pay for goods, services, and investments. When liquidity is low, meaning there isn't a lot of money available, then demand slows. When liquidity is high, meaning there's a lot of money available, then demand increases. For example, if you make $100,000 per year, then you have a certain amount of money available to you to spend. If suddenly you were making $142,000 per year (a 42% increase) you would have more money available to spend, and would probably spend more money.

Interest rates affect liquidity by making borrowing money easier. For example, you want to buy a house. If the house you want to buy would result in a $1 million loan at 2% (which was possible during the pandemic), then the mortgage payment would be about $3,700. Now, with mortgage interest rates at 6%, that payment would be about $6,000, a 62% increase. To keep the payment at about $3,700 with the same 6% interest rate, the loan would need to be no more than $620,000. Here in California, in some areas, it may be very difficult to find a home at that price, and that makes people not want to buy a new home, decreasing demand. And that's exactly what the Fed is trying to do with interest rate increases... crush demand. If the Fed can bring demand down enough with interest rate increases (and removing liquidity from the system), then prices should stop rising at the same rate they once were. Not only that, but prices may even begin to fall. We've already seen that in some real estate markets. It remains to be seen if goods and services will also experience price declines in general, though used car prices, energy, and gas prices have come down already.

Even if the Fed is able to initially crush some demand to make inflation slow down, there's the possibility of the issue of falling prices becoming appealing to buyers, which would again increase demand and cause inflation to rise again. For example, with mortgage rates at 6%, what if that home you wanted suddenly dropped in price dramatically where the loan would only be $600,000 with the $3,700 payment? You might jump on it. And so might many other homebuyers.

How can that scenario be prevented? By making those potential homebuyers unable to buy that home no matter what its price is. To do that, people need to have a lack of money, which means they need to lose jobs. Make no mistake about it, the Fed is looking to bring down the labor market. There are currently more job openings than there are workers available to fill them.

To truly crush demand and bring inflation down, the Fed needs to cause unemployment to increase, so that people don't have as much money to spend, in order to keep supply up and demand down. By making business expenses increase with higher interest rates, businesses will find that they can no longer afford positions they have open, and may even need to layoff workers. That will bring down the number of available job openings, and bring down worker demand, which could bring down wages and eventually cause unemployment to rise.

As you can see, the Fed's target Fed Funds Rate is an important part of the economy. Increasing and decreasing the interest rate could affect not only the interest you pay on a loan and the interest you receive with a savings account, but also supply and demand, the labor market, the amount of inflation, and more. And all of that has an effect on us an individuals and what we're able to do with our money.

Incorporating interest rates and inflation into your short-term and long-term financial plan can seem like a Herculean task. Fortunately, Escient Financial is here to help you implement a financial plan designed to take interest and inflation into account, as well as other factors, to enable you to reach your goals. To find out how, feel free to...