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You might have heard of the Federal Reserve and the terms federal funds rate, and discount rate.
But what do they mean? And more importantly, how do they affect you?
The short answers are:
- The Federal Reserve is the central bank system providing financial services to banks and government entities. It does not provide services directly to consumers.
- The Federal Funds Rate is set by the Federal Reserve. It is the target interest rate they wish to have banks charge each other to borrow money from one another overnight to maintain their required “reserve” in the central bank.
- The Discount Rate is the interest rate the Federal Reserve charges banks to borrow directly from them. This rate is set higher than the target fed funds rate.
In December 2008 during the height of the Great Recession, the effective federal funds rate was cut to .09%. It remained between 0-.25% until December 2105, then gradually increased over the years to 2.25-2.5% in December of 2018.
Since then, the United States Federal Reserve has cut the Federal Funds Rate three times in 2019. As the year comes to a close, it now sits between 1.50-1.75%.
Read on for more about the Federal Reserve and interest rates, and how they can affect you.
What is the Federal Reserve or Fed?
The Federal Reserve System, created by Congress in 1913, is the United States central bank system made up of 12 Federal Reserve Banks and their 24 branches, the Federal Reserve Board of Governors, and the Federal Open Market Committee.
The Fed is essentially responsible for “promoting the effective operation of the U.S. economy.” To do so, it
- Conducts Monetary Policy
- Promotes Financial System Stability
- Supervises and Regulates Financial Institutions and Activities
- Fosters Payment and Settlement System Safety and Efficiency
- Promotes Consumer Protection and Community Development
The Fed performs actions (monetary policy) “to influence the availability and cost of money and credit to help promote national economic goals.”*
To manage short-term interest rates and influence the availability and cost of credit in the economy, the Fed varies the federal funds rate by establishing and conducting:
- Reserve requirements (funds a depository institution must hold in vault cash or on deposit with Federal Reserve Banks against deposit liabilities),
- The discount rate (the rate the Fed charges banks to borrow money) and
- Open market operations (purchase and sale of securities in the open market by a central bank)
These actions affect interest rates on credit cards and on auto, home, and other consumer loans. They can eventually affect stock prices, currency exchange rates, and wealth.
The Fed’s monetary policy influences spending, investment, production, employment, and inflation in the United States.**
Federal Open Market Committee
The Federal Open Market Committee, or FOMC, is the monetary policymaking arm of the Federal Reserve, and eight times per year it meets to set the fed funds rate.
As conditions in the economy change, the FOMC may raise or lower its target for the federal funds rate.
Changes in other interest rates and in broad financial conditions normally follow. In turn, this affects the spending decisions of consumers and businesses, impacting the economy, employment, and inflation.
During strong economic times, the FOMC may increase rates to keep inflation in check and decreases rates to revive a faltering economy.
When the FOMC cuts the federal funds rate target, known as easing monetary policy, lower interest rates for consumer borrowing result, which should lead to:
- Increasing spend on durable goods
- Housing becoming more affordable, leading to more home purchases
- Refinancing of existing mortgages to lower rates
- Higher stock prices building wealth for investors and those saving for retirement
- Increased business investment projects
But actions by the FOMC aren’t the only things that can affect the economy. The following things may also impact employment, spending, and inflation.
- Government spending programs
- Corporate and consumer confidence
- Lenders’ credit standards
- Decreases or increases in the production of goods and services
What Changes in the Fed Fund Rate Means for You?
When the fed fund rate increases and interest rates rise, the price of borrowing money is greater.
It also affects your community as less consumer spending occurs. If retailers and businesses suffer, they may be forced to let employees go and unemployment may increase.
One saving grace? The interest you earn on savings in the bank will increase.
Declining interest rates resulting from a cut to the federal fund rate provide benefits, but some potential problems for you too.
When rates are lower, the cost of borrowing money decreases and more people choose to take out loans.
Obtaining a loan to buy a house, car, or other pricey item gets easier. But this could mean consumers increase their debt and save less because money on deposit in the bank is also earning less interest.
Declining rates boost the economy and businesses likely earn more profits. In turn, this benefits stock investors.
There’s a good chance you’ve recently heard the phrase ‘negative interest rates’. If the FOMC continues to cut the fed funds rate, there will be an increasing concern the United States could enter a negative interest rate environment.
While this circumstance has not yet occurred in the U.S., it has been tried by Sweden, the European Central Bank, Switzerland, Denmark, and Japan.
What Are Negative Interest Rates?
A main goal of lowering the fed fund rate is to make it easier for consumers and businesses to borrow money.
The idea being, when it becomes less profitable for banks to lend excess funds to each other and it costs less to borrow funds to meet their reserve requirement, they will be less likely to hold onto excess funds in their reserves, and more profitable lending out to the consumer market.
If the federal fund rate were to become negative, it would mean that it would actually cost banks money for holding onto any excess reserves. But negative rates also cut lenders’ profits which could affect their ability to make loans.
While negative interest rates are uncommon around the world, they have existed in some countries since 2014 when the European Central Bank implemented a -0.1% rate to lending institutions holding excess reserves in the Central Bank.
Since then, several other European countries like Sweden, Denmark, and Switzerland have dropped to negative interest rates. Even Japan is currently under a negative interest rate environment.
Why are these countries in this situation? For the most part, it is because they are still recovering from the last financial crisis.
These countries have seen weak economic growth since the crisis, and, to different extents, turned to negative interest rates to mitigate certain economic risks.
These rates are set in place in hopes that businesses will be able to produce greater output, give the country an advantage with exports, and prop up prices of stocks and securities.
Benefits of a Negative Fed Fund Rate
As stated, the goal of negative interest rates is to boost economic activity. Businesses and consumers qualifying for low rates can borrow money and actually, in theory, pay less than they originally owed.
So, if you’re a business owner or someone looking to obtain a large loan, lower interest rates are welcome.
Additionally, companies that rely heavily on exports receive a trade advantage because, due to the decrease in the exchange rate, foreign consumers effectively pay less for the product (so they can buy more).
Drawbacks to Negative Interest Rates
An important drawback to such low-interest rates is the impact they have on savers.
Those who choose to keep money in their accounts are punished by lower returns. They also face potential charges on the savings they lend to their banks.
Further, consumers are more likely to take risks they wouldn’t typically consider under normal conditions. If they can’t make returns on the money in the bank, they may take on riskier investments or projects to try to meet their earnings goal.
While negative interest rates lower our borrowing costs they also weaken the country’s currency.
There has also been evidence of certain market distortions, like higher equity prices, and uncharacteristically high levels of debt taken by consumers due to the low-interest rate environments.
Both of these facts lead to bubbles in many different markets in the economy.
Are Negative Interest Rates Likely To Happen?
This question is very much up for debate. However, it is worth noting that such low-interest rates usually stem from economic distress.
As previously indicated, in 2008 a fed fund rate of 0-0.25% was part of the quantitative easing effort put in place by the Federal Reserve to help counteract the impact of the recession.
It may be concerning to some that the Fed is currently cutting rates during what is now around a 10-year economic boom in the United States.
Further, the national deficit has been increasing greatly over the last two years. This increase could prove to be a serious problem when the country inevitably runs into an economic slowdown.
This is because interest rate cuts will have already been utilized, making it more difficult to take on debt should the government want to increase spending to spur economic momentum.
Essentially, they are using the tools to help the country out of a recession before it is even in one.
On another note, negative federal fund rates could be used as a strategic tool during a state of turmoil such as the current trade talks with China. They may act as a sort of insurance policy should there be a poor, or a very drawn-out, resolution.
Having a weak currency would allow domestic exporters to have an advantage in trade, as mentioned earlier; which could help counteract any negative impacts from the fallout of the China trade agreement.
Will it happen, though?
The most recent comments by the Chairman of the Fed, Jerome Powell, were that the United States is not in the right place for such conditions. However, former Chairman of the Fed, Alan Greenspan, recently said that it “It’s only a matter of time” before the United States faces this environment.
Vicki and Amy are authors of Estate Planning 101, From Avoiding Probate and Assessing Assets to Establishing Directives and Understanding Taxes, Your Essential Primer to Estate Planning, from Adams Media.