In today’s world of 24/7 cable TV and Internet news, people are more likely to be knowledgeable about financial and economic matters than in past generations. For example, we would venture to guess that most people have at least heard of the Federal Reserve, or, as it is usually referred to, the Fed.
However, having heard of the Fed is quite different from understanding what the Fed actually does and how its actions influence our financial lives. Let’s explore the Fed’s role in the U.S. economy and how its actions affect the broad economy and interest rates in particular.
What is the Federal Reserve and what are its Main Tools?
The Federal Reserve is the central bank of the United States. It was created by Congress in 1913 to provide a safer, more flexible and more stable U.S. monetary and financial system. (Its ancestor was the Bank of the United States, championed by Alexander Hamilton and authorized by Congress in 1791 to deal with Revolutionary War debt.) A primary role of the Fed is to manage the nation’s monetary policy by influencing financial and credit conditions, with the goal of achieving both relatively low unemployment rate (technically called “full employment”) and stable prices.
The Fed pursues these goals, in part, through two forms of monetary stimulus. The first form is setting the Target Federal Funds Rate, which is the interest rate at which banks loan money to each other. By raising or lowering this rate, or keeping it unchanged, the Fed influences (either directly or indirectly) most consumer loan rates in the U.S. In this way, the Fed also indirectly regulates the money supply.
The Fed can also influence mortgage rates through quantitative easing, which is the purchasing of financial assets -- such as mortgage-backed securities and U.S. Treasuries -- from commercial banks and institutional investors. Buying these securities increases demand for them, which lowers the rate they must pay to attract investors, which helps drive down mortgage rates. Selling these securities does the opposite.
Now that we’ve provided background on the tools available to the Fed, let’s look at how Fed actions can influence the rates you pay for a variety of consumer loans:
- Mortgage rates — While the fed funds rate is not tied directly to mortgage rates, it indirectly influences them because its movements affect what it costs for lenders to borrow money. If it costs your bank more to borrow money, your bank is going to pass this cost on to you in the form of higher mortgage interest rates.
- Credit cards and home equity lines of credit (HELOCs) — Interest rates on most variable rate credit cards and HELOCs are based on the prime rate, which in turn is tied to the federal funds rate. The prime rate is a consensus interest rate based on the rates charged by the ten largest banks in the country.
Banks loan money to their best customers at the prime rate, and then add to the prime rate based on a customer’s creditworthiness. This is what it means when you hear “Prime plus one” or “Prime plus two.” The prime rate changes when seven of the ten big banks change their rate, and that is trumpeted on the financial news.
- Certificates of Deposit (CDs) and savings accounts — Interest rates paid out on CDs and savings accounts mirror the federal funds rate very closely. If the Federal Open Market Committee, which meets regularly to deliberate changing the federal funds rate or leaving it alone, raises or lowers the federal funds rate, you can be almost sure that CD and savings account interest rates will follow this direction.
Banks further adjust CD and savings account rates based on the current level of loan demand. If loan demand is relatively high, these rates may increase slightly. The bank earns its profit by maintaining a spread between the interest rate it pays on deposits and the rate it charges on loans.
- Auto loans — While auto loan rates are influenced by the federal funds rate, they do not move in tandem with it like credit card, HELOC and CD rates do. The Fed moves auto loan rates mainly by buying and selling U.S. Treasuries on the open market. Buying Treasuries causes rates on auto loans with similar maturities to fall, while selling them does the opposite. Market forces like the resale value of used cars and the anticipated direction of future inflation also affect auto loan rates.
New Fed Chairperson Takes the Helm
With the recent appointment of Janet Yellen to replace Ben Bernanke as the Federal Reserve Chairperson, there is likely to be even more attention focused on the Fed in the weeks and months to come. In particular, Yellen noted in her first major policy speech to the Economic Club of New York on April 16 that the Fed is not likely to raise interest rates until its inflation and unemployment goals are achieved.
During this speech, Yellen said she believes the economic recovery, though sluggish at times, “has come a long way.” She added that an effective Federal Reserve policy must respond to the “unexpected twists and turns” of an uncertain economy. Looking back on the past seven years, which included both the “Great Recession” and “Reluctant Recovery,” it’s safe to say there will be many twists and turns to come.
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