Updated: Aug 19, 2019
By Anjiline Sirsikar
August 18 2019
North Atlantic Policy Center
How Interest Rates Are Determined and How They Affect Your Portfolio
The Federal Reserve is responsible for maintaining full employment at a range between 4 to 5 percent. Concurrently keeping the inflation low. There are two types of interest rates that fed has to balance for continued economic growth. The discount rate and federal fund rate. This paper discusses these interest rates, and explains how it impacts the overall economy.
The Federal Reserve is very influential in how it directs the interest rates. The fluctuations in the interest rates impact various levels of the economy differently. For instance, when the interest rates are low, capital is easier to acquire this results in higher economic growth. If left unchecked the result is too much money chasing too few goods, leading to inflation as businesses realize they can charge higher prices for goods and services.
Here is how the Federal Reserve can influence the direction of interest rates:
By raising or lowering the discount rate.By indirectly influencing the direction of the Federal funds rate.
The discount rate and the federal funds rate are both used by banks to maintain reserve requirements. The difference being, banks apply discount rates when borrowing from Fed, and use the federal funds rate when borrowing from other banks.
Discount Rate - is a type of interest rate charged by banks when they borrow funds overnight directly from one of the Federal Reserve Banks.
The Federal Funds Rate – is a type of rate banks charge each other for overnight loans. Banks borrow from each other to meet Fed’s requirement by keeping a certain percentage of assets in the form of cash on hand or be deposited in one of the Federal Reserve banks.
The main objective behind this type of lending is to establish a required ratio of reserves to deposits; an increase in this ratio means more cash needs to be kept in the vault at night, making it difficult (and expensive) for funds to be acquired. This means money supply is tight. On the other hand, when the reserve requirement is lowered, the money supply is loosened, as less cash needs to be kept in the vault, making it easier to acquire capital.
The increasing and decreasing cost of acquiring funds is directly passed on to consumers as banks adjust their prime lending rate. Notably, the prime lending rates is not uniform. For instance, Bank of America has one lending rate, while the U.S. Bank has another lending rate. The Wall Street Journal places an integral role, reporting on the polling of nation’s thirty largest banks; when all twenty – three of those institutions have change their prime rates, the WSJ reports on the published rates.
Current Federal Reserve Interest Rates and Why They Change
Recently, the Fed lowered the federal funds rate to 2.25%. The benchmark rate is a marked indicator of representing the current health of the economy. The fed fund rate is critical in determining the current economic outlook. This rate controls the short -term interest rates which include; bank prime rates, adjustable rates and interest- only loans, and the credit card rates.
The 2008 recession caused the Fed to decrease its benchmark rate to 0.25%, which is equivalent to a zero. The zero-rate lasted till 2015. In 2015, Fed increased the rate to 0.5 %. The Federal Open Market Committee (FOMC) raised the funds rate a quarter – point to 2.5% on December 19, 2018.
In 2013, Fed lowered its quantitative easing programs. This process was widely accepted as a massive expansion of Fed’s open market operations tool. In 2017, fed still carried a $ 4 trillion debt from quantitative easing. In this context, quantitative easing refers to large scale asset purchases, where by central bank buys predetermined amounts of government bonds or other financial assets in order to inject liquidity directly in to the economy. Late in 2017, it allowed the holdings to decline, by July 2019, this number dropped to $3.8 trillion, and the fed announced it would no longer reduce its holding.
Note: The lack of Fed rate hike means banks won’t pay higher interest on your savings, but they will also not charge you more on loans. The change affects both wages and consumerism.
The call for fed to balance its interest rates does impacts the overall economy. Therefore, understanding how these interest rates affects individuals’ personal budget, and how to avoid further future financial mistakes is key. Here are few smart moves when taken will help mitigate and avoid future financial troubles.
Here are five precautionary steps to build wealth and avoid financial strains:
1. Pay off any outstanding credit card debt. The interest rate will go up as the Fed raises rates.
2. Avoid locking into a three- or five-year CD. You'll miss out on the higher returns when the Fed raises rates again in 2019.
3. Shop around to take advantage of the best rates on your savings accounts. Big banks raise their rates more slowly than smaller ones.
4. Don't procrastinate if you need to buy appliances, furniture, or even a new car. Interest rates on those loans are going up. They'll only get higher over the next three years. The same is true if you need to refinance or buy a new house. Interest rates on adjustable-rate mortgages are going up now. They'll continue to do so over the next three years, so question your banker about what happens when the interest rates reset. They will be at a much higher level in three to five years.
You might be better off with a fixed-rate mortgage.
5. Talk to your financial adviser about reducing the number of bond funds you have. You should always have some bonds to keep a diversified portfolio. They're a good hedge against an economic crisis. But this isn't the right time to add a lot of bond funds. Stocks are a better investment as the fed continues to raise rates.