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Fed changes rates...what does it mean?

The man to watch:

Alan Greenspan, chairman of the Federal Reserve Board of Governors. The markets swoon when he waxes eloquent on the economy

Definitions

Direction is critical

Increase is near: What to expect

Capital markets react

What happened in 1996?

What happened in 1997?

 

 

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Alan Greenspan has spoken, the markets have swooned, so what happens next? He told the House Budget Committee Wednesday that "the economy has been on an unsustainable track." Interpretation: Inflation is creeping in, the Fed will have to act. What does that mean to consumers? What follows here is an analysis of what it means and why you should follow the Fed.

The first step in understanding how that headline, "Fed changes rates", affects you is to understand which rates are at issue. The Federal Reserve can influence the economy by changing the Federal Discount Rate or the Federal Funds Rate. Although those rates are very different, a change in either has the same effect: Increases slow down the economy and prevent inflation; decreases spur economic growth. Both affect your budget.

The Federal Discount Rate is the rate charged on loans from Federal Reserve Banks to its member banks. Changes in the discount rate generally have been infrequent. From 1980 through 1990, for example, there were only 29 rate changes.

If Fed cuts the rate
However, the Fed cut the discount rate seven times in the period of economic sluggishness from December 1990 to July 1992 -- from 7% ultimately to 3%. From May 1994 to February 1995, when the Fed was concerned about the threat of inflation, it raised the discount rate four times -- from 3% to 5.25%. The last time the Federal Discount Rate was changed was in January 1996 when it dropped to 5% from 5.25%.

The Fed Funds Rate works differently. Banks do not earn any interest on the money they are required to have on deposit with the Federal Reserve. When reserves climb above the minimums required, banks gladly loan out that excess to other banks that need to add money to their reserves. The lending banks charge interest for this service. The rate of interest they charge is known as the "Federal Funds Rate" or Fed Funds Rate.

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Direction is critical

When a Fed change is announced, the direction (up or down) of the Fed change is critical. Increases in the discount rate generally reflect the Federal Reserve's concern about inflationary pressures, while decreases often reflect a concern about economic weakness.

How does this affect you? Think of the bank as a wholesaler. If it costs your bank more to borrow, that cost is passed on to you, the consumer. If the rate drops, those savings are also passed along.

This is most frequently done in the form of the bank's prime rate. The prime rate is the rate charged by a bank to its "best" or prime customers. It is often used as an index or a base rate for mortgages, home equity loans, home equity lines of credit and credit cards. Therefore when the prime rate changes, the rate you are charged for those types of loans will adjust accordingly. If your rate goes up, so will your payments. It also has a positive effect in that banks pay you more for your deposits.

Increase is near: What to expect
Now, without delving too deeply into monetary policy, let's look at what you need to know as a consumer. A newspaper headline reads: "Greenspan says increase near." Translation: The chairman of the Federal Reserve Board of Governors (Alan Greenspan) thinks, along with his fellow FOMC (Federal Open Market Committee) members that the economy is growing too fast. If the economy is growing fast then inflation will set in. Inflation increases everyone's cost of living. The Fed doesn't want this so the committee increases the Federal Discount Rate or the Fed Funds Rate. The banks pass the increased cost of doing business along to the ultimate users of credit -- consumers.

How do consumers react? The cost of credit makes the monthly payment on that new refrigerator too high. They don't buy it this month. The stores aren't selling their inventory as quickly, and they cut back on factory orders. The factory isn't getting as many orders, so management slows down the assembly lines. They don't want to produce goods they cannot sell. Factory workers put in less overtime, or they may get laid off. They won't have as much money to spend, so they cannot buy as much. The cycle continues and the economy slows down, inflation is averted and Alan Greenspan and his fellow board members have saved us from destruction.

Capital markets react

There is a secondary effect to any change or even rumored change in Fed policy. It effects all of the capital (stocks and bond) markets. The Fed, by making a change in the rates, is in fact making a statement about the economy. This causes all of the capital markets to shift their rates to meet the Federal Reserve' s expectations.

Therefore an increase in the Fed rates will cause the capital markets to increase the required rates on all types of stocks and bonds including U. S. Treasury obligations. The 10-year T-Bond is the benchmark for 30-year mortgages. It goes up, so will the interest rate on any new mortgages. If the 1-year T-bill goes up, so will any 1-year adjustable-rate mortgage.

What happened in 1996?
What happened the last time the Federal Reserve changed the Federal Discount Rate? Remember the last change was a decrease in rates. In the 1997 economy we are talking about an increase.

Click on the chart above
. You can see that a drop in the rates had an immediate effect that reduced the mortgage and car rates. But the effect on the mortgage rate was not long lasting. Within 60 days of the rate drop, the interest rates were back up again. However, the change was good news for car buyers. That rate fell 0.21% immediately and continued to fall another 0.12%.

What happened in 1997?

Click on the chart at left. You will see that conversely, if the Fed increases rates in this economy, expect the cost of borrowing to increase. This happened in March of this year when the Federal Funds Rate was increased to 5.50%.


--Posted: October 1997

Resources:

Federal Reserve Board

Meet Alan Greenspan

What's the Federal Open Market Committee?

Feds on the Web

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