Have you benefited from the strong job market to increase your income last year? Are you hesitant to buy a home until you find a cheaper deal with a lower interest rate?
Believe it or not, those decisions may be linked to what is happening with the strongest central banks in the world: the Federal Reserve.
What is the Federal Reserve?
The Federal Reserve is the central bank of the United States and one of the most complex institutions in the world. The Fed is best known as the regulator of the largest economy in the world, determining how much it costs businesses and consumers to borrow money. Low borrowing costs encourage companies to expand their workforces or invest in new initiatives. However, higher interest rates deter companies from hiring and consumers from purchasing at elevated prices.
1. The Fed’s decisions affect where banks and other lenders set their interest rates
High Fed interest rates translate to higher borrowing costs to finance everything from cars and homes to your credit card purchases. Key interest rate indicators follow the Fed’s movements closely, influencing some of the most common loan products – like the prime rate and the secured overnight financing rate.
When interest rates are higher, the availability of money in the financial system also tends to decline, another factor that makes borrowing more expensive. Sometimes, rates rise even on the mere expectation that the Fed will increase interest rates. As was the case following three major bank failures, lenders may become more cautious in lending money – meaning that getting approved for a loan could also become more difficult.
For example, here’s how much the cost of financing various large items has increased this year after the Fed’s 5.25 percentage point hike:
Product
Week ending July 21, 2021
Week ending October 25, 2023
Percentage point change
30-year mortgage
3.04 percent
7.23 percent
+4.19 percentage points
Home Equity Line of Credit (HELOC) for $30,000
4.24 percent
10.03 percent
+5.79 percentage points
Home equity loans
5.33 percent
8.92 percent
+3.59 percentage points
Credit cards
16.16 percent
20.72 percent
+4.56 percentage points
Used car loan for four years
4.8 percent
8.31 percent
+3.51 percentage points
New car loan for five years
4.18 percent
7.72 percent
+3.54 percentage points
Borrowers often see price increases reflected in one to two billing cycles – but only if they have a variable-rate loan. Higher rates will not affect consumers who secured a fixed-rate loan.
One place where higher rates have been evident: credit cards. The average interest rate on credit cards soared to an all-time high throughout 2023, reaching 20.72 percent since early October. However, higher interest rates will not impact individuals who pay off their credit card balance in full each month.
“Borrowing costs tend to rise first after interest rate hikes by the Fed,” according to Liz Ewing, former CFO of Marcus by Goldman Sachs and now CFO of Sapient Capital. “Banks are not required to align their interest rates with the Fed’s interest rate, so each bank will respond to the Fed’s rate announcement and adjust rates in its own way.”
While mortgage rates generally follow the Fed, they can often become decoupled. Mortgage rates primarily track the yield on the 10-year Treasury bond, which is driven by similar macroeconomic forces. But fundamentally, these yields rise and fall due to demand from investors.
May
investors are pouring more money into these safe investments when they expect the economy to slow down or contract, which means mortgage rates may fall even if the Federal Reserve is raising interest rates. Long-term yields, and thus mortgage rates, may also decline when the Fed is in the midst of a plan to buy assets to lower long-term interest rates, making the U.S. central bank the largest buyer in the market.
Mortgage rates began to rise in the fall of 2023, reaching 8.01 percent on October 25, the highest level since August 2000. This was due to the yield on the 10-year Treasury bond reaching new highs, surpassing even 5 percent on October 23 for the first time since 2007.
However, things can change rapidly. The October inflation report showed that the core yield fell by 75 basis points in just over a month. This helped alleviate pressure on the 30-year mortgage, which dropped to 7.23 percent on December 6, according to Bankrate data.
“We need to see a tangible improvement in core inflation and a trajectory toward slower economic growth before we see an actual decrease in mortgage rates,” said McBride. “We’re not there yet.”
2. High Fed rates not only make borrowing more expensive — they also make it harder to get approved
One reason high interest rates slow demand is that they limit households’ ability to secure ongoing credit. Consequently, limited access to credit leads to less spending — impacting demand and reducing some inflationary pressure.
A report from the Federal Reserve Bank of New York on July 17 showed that rejection rates for any type of credit — including mortgages, credit cards, and auto loans — reached the highest level in five years. In November, an update to the Federal Reserve’s credit access survey showed that another share of auto loans was not approved, rising to a record level. Rejection rates were higher for individuals with credit scores below 680.
This phenomenon reflects one of the key characteristics of a high-interest-rate environment: lenders become more selective in granting loans to those they deem riskier, fearing they may not be able to repay the borrowed amount. This means that rates may rise faster for borrowers considered to be higher risk.
Financial institutions may fear that the risk of default will be higher because monthly payments become more expensive when interest rates are high. Take a 30-year mortgage as an example. A $500,000 mortgage would have cost you $2,089 a month in principal and interest when rates were at their all-time low of 2.93 percent, according to an analysis using Bankrate national survey data. With the 30-year mortgage rate rising to 7.23 percent, that same payment now costs $3,404 a month.
“Tighter credit affects borrowers with less-than-excellent credit ratings more significantly — whether the borrower is a consumer, business, municipality, or national government,” said McBride. “Lending does not stop but gets concentrated more intensively on borrowers who present the least risk of default.”
3. Fed interest rates affect savings account yields and certificates of deposit (CDs)
You may not be able to borrow at cheaper rates than before, but high interest rates have some positive aspects, especially for savers: ultimately, banks end up raising yields to attract more deposits.
Average
The return on savings is now three times what it was at this time last year, having increased from 0.23 percent to 0.58 percent as of December 4, the highest level since March 2007, according to national Bankrate data.
At the same time, a five-year certificate of deposit (CD) was paying 0.37 percent at the beginning of January 2022, before the Fed began raising interest rates. Today, it offers an average yield of 1.45 percent.
However, major banks in the country rarely raise yields at the same pace or to the same extent as the Fed’s interest rate. These traditional banks are not interested in deposits, especially at this time.
But there are banks that offer more in interest, which can be found and can help consumers maintain some purchasing power – and even outpace inflation. These yields are available at online banks, which can offer more competitive interest rates because they are not burdened with the operating costs that traditional banks with physical branches incur.
A significant example of this: 14 banks classified as the best high-yield savings accounts in July 2021 offered an average yield of 0.51 percent, with the highest yield at 0.55 percent and the lowest yield at 0.40 percent. At that time, that was about nine times the national average.
By December 12, the top ten ranked banks for 2023 offered an average yield of 5.12 percent, nearly ten times the national average and up 400-500 times higher than the returns from Chase and Bank of America. Those banks offer yields up to 5.4 percent and up to 4.65 percent, all of which outpace overall inflation. Use Bankrate’s tools to compare how much you could earn by moving your account to one of the best offers from Bankrate.
“Retail savings rates often move more slowly in a rising interest rate environment, but they can also decline more slowly in a falling interest rate environment,” said Ewing. “Customers with high-yield savings products may find good value in the long run.”
As the possibility of the Fed pausing soon approaches, experts say it may also be time to secure long-term CDs. Banks often lower interest rates as soon as it seems the Fed will not raise rates any further.
“If you have your eye on a certificate of deposit with a term of two to five years, now is the time to get it,” according to McBride.
4. Fed’s Decisions on Interest Rates Affect Stock Markets – and Thus Your Portfolio or Retirement Accounts
Cheap borrowing rates are often good for investments because they encourage investors to take risks in an attempt to compensate for weak returns from bonds, fixed income, and certificates of deposit.
On the other hand, markets may suffer from the possibility of rising prices. Part of this is by design: effectively, the U.S. central bank is pulling liquidity from the markets when it raises interest rates, leading to volatility as investors rearrange their portfolios.
This is also due to concerns: when prices rise, market participants often become anxious that the Fed may become too reckless, significantly slowing growth and possibly pushing the economy into recession. These concerns hit stocks in 2022, with the S&P 500 recording its worst performance since 2008.
However, it seems that investors have some hope. The S&P 500 has risen over 21 percent since the beginning of the year and is now just 2 percent off its all-time high, with economic strength and slowing inflation continuing.
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Markets can be volatile, which means it’s important to maintain a long-term perspective, avoid making hasty decisions, and continue regular contributions to your retirement account. When the Federal Reserve raises interest rates, it’s largely to ensure the financial system doesn’t get out of hand by growing too quickly. Additionally, low stock prices can create tremendous buying opportunities for Americans hoping to enhance their long-term investment portfolios.
“Ordinary investors should focus on the big picture: a growing economy is an environment that allows companies to increase their profits,” said McBride. “Ultimately, a growing economy and higher corporate profits are good for stock prices. It may not be a smooth road between here and there.”
5. The Federal Reserve Has a Significant Impact on Your Purchasing Power
The Federal Reserve’s interest rate decisions go beyond just affecting the price you pay to borrow money and the amount you earn on savings. All of those factors have a clear impact on the economy – and for consumers, that also means their purchasing power.
Low interest rates are aimed at stimulating the economy and boosting the labor market enough that supply cannot meet demand – exactly what happened in the aftermath of the coronavirus pandemic. All of this can lead to inflation.
High Federal Reserve interest rates are the primary way to impact price increases, although it’s important to note that consumers won’t feel the effects immediately. They do not…
Source: https://www.aol.com/6-key-ways-federal-impacts-051048216.html
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