Inside the Fed's toolbox
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The Fed has 3 ways of influencing the federal funds rate, which is the rate at which banks lend to each other overnight and is used as the benchmark for a range of consumer interest rates.
- Through "open market operations," it buys Treasury securities to shrink the supply of government debt, thereby increasing the price and bringing down the interest rate on the securities. Or, it sells Treasuries into the market to increase the supply, lower the price and raise interest rates.
- It sets the discount rate, which is the rate at which banks may borrow from regional Federal Reserve Banks. If the discount rate is raised, banks bear higher borrowing costs and tend to curb their lending, boosting interest rates. If it's lowered, banks generally make credit more widely available, and rates fall.
- It establishes reserve requirements, or the amount of capital that banks must hold as security for the deposits on their books. If reserve requirements are increased, banks tend to reduce their lending activity; if they're loosened, banks give loans more freely.
Making credit available
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The Fed's actions influence the availability of credit. When the Fed is boosting the money supply -- for instance, by buying government bonds from the market -- lenders are more willing to extend credit.
At the 8 regularly scheduled FOMC meetings a year, committee members decide how many securities to buy and at which maturities, after they pore over data and reports from across the country on the labor market, inflation and economic growth.
The committee then unveils its new target range for the federal funds rate, and shares its members' economic projections in an announcement closely watched by traders and policymakers around the world. Within seconds, financial markets begin to adjust, affecting your pocketbook in numerous ways.
Influencing the prices you pay
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The Fed's actions indirectly have an impact on the prices you pay at the grocery store, gas pump and other retail outlets.
That's because the cost and availability of money affect people's willingness to pay for goods and services. When money is cheap and plentiful, there's more demand and prices tend to rise.
"When the economy's doing really well and the labor market is good and the unemployment rate is falling, that's when you have concerns about employers hiring and bidding up wages and inflation rising," Faucher says.
It's easier to stop inflation than it is to break out of a deflationary cycle, says Ara Oghoorian, a CFP in Los Angeles who previously worked for the Fed as a bank examiner.
When there's been weak inflation, the Fed has kept rates low to prevent a repeat of the "lost decade" of stagnant economic growth in Japan when prices fell, people delayed purchases in hopes of cheaper prices, and that caused prices to fall even further.
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Affecting the job market
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You probably never thought of the Fed the last time you updated your resume. But the Fed is thinking of you. At every meeting, monetary policymakers consider labor market data as they make decisions aimed at achieving maximum employment.
They look at numbers such as:
- Payroll changes.
- Labor force participation rate.
- Duration of unemployment.
The Fed can only indirectly affect the job market, by lowering interest rates to encourage more borrowing. That prompts businesses to take out loans to purchase new machinery or invest in new equipment and encourages consumers to borrow in order to buy goods and services, says Faucher.
"That increases aggregate demand. Then businesses are producing more and they need to hire more workers," he says. "That, in turn, leads to a better labor market and lower unemployment rate."
Putting credit card rates in motion
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The majority of credit cards charge variable interest rates tied to an index, usually the prime rate, which is about 3 percentage points above the federal funds rate. When the federal funds rate changes, the prime rate does as well, and credit card rates follow suit.
"What the Federal Reserve does normally affects short-term interest rates, so that affects the rates that people pay on credit cards," Faucher says.
When the Fed sets a low rate, you are encouraged to borrow to buy a new appliance, make home repairs or conduct similar purchases that stimulate the economy. Of course, the annual percentage rate you pay on your credit card can rise for other reasons, such as late payments or the end of a low introductory rate.
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Nudging CD rates
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If you rely on interest from certificates of deposit for income, you're probably not too happy with the Fed keeping interest rates at rock bottom.
"Retirees want to live on the interest on their CDs," Reese says. "The Fed determines whether they can do that or not."
CD rates largely follow the short-term interest rates that track the federal funds rate. However, Treasury yields and other macroeconomic factors can influence rates on long-term CDs.
Individuals should focus on the real rate of return on CDs, after inflation is taken into account, says Casey Mervine, a senior financial consultant at Charles Schwab. In the late 1980s, for instance, you could earn double-digit rates on CDs, but with inflation also in the double digits, your actual earnings were much lower due to the erosion of your purchasing power.
Recognize that the Fed's actions are intended to prompt you to invest in higher-yielding bonds and stocks, thereby fueling the economy.
"There's an old adage, 'Don't fight the Fed,'" Mervine says. "When the Fed can keep you from earning anything in safe money, you really have to take some measured risk."
Driving auto loan rates
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The federal funds rate chiefly influences short-term interest rates, because it's a rate on money lent overnight between banks, but it also trickles through to medium-term fixed loans, such as auto loans.
"The rate the Fed sets ends up affecting almost everything in our economy," Reese says.
Whether the lender is a credit union, bank or other institution, it will price auto loans relative to the prime rate, which moves up and down in sync with the federal funds rate.
If a bank is charging its customers 4.64% for a 60-month loan on a new car, and the federal funds rate increases by a half percentage point, the lender will bump up the rate to about 5.14%. Auto loans also benefit from being sold into the secondary market, making more investors' dollars available to finance your car purchase or refinancing.
Turning the key on mortgage rates
When the Fed lowers the federal funds rate, lenders can finance home loans more cheaply. As a result, they can reduce the interest rates they charge for a fixed-rate mortgage.
In recent years, the Fed has kept the federal funds rate low in an attempt to stimulate the housing market.
"The Fed is making homes affordable at all-time levels with low interest rates on mortgages," Mervine says. "A lot of people are underwater, but if they can save and pay down their prior mortgage, they can refinance at extremely low rates."
The Fed can even control the shape of the yield curve, or the relation between interest charged for 1-year loans, 3-year loans, 5-year loans and so on. "If they want to bring down 10-year rates, they'll go out and buy 10-year securities," says Oghoorian.
Mortgages are pegged to the 10-year Treasury rate, because refinancings and early payoffs effectively give a 30-year mortgage a 10-year lifespan, Oghoorian says. Competition and market conditions also affect rates.
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Touching home equity lines
Also directly tied to the federal funds rate: your home equity line of credit, or HELOC. That's because HELOC rates are typically linked to the prime rate. When the Fed raises or lowers its target rate, HELOC rates follow suit.
A HELOC is a great way to refinance or restructure your debt, Mervine says, "if you've got home equity that you can use to consolidate high-interest credit card debt or other less accommodative types of debts."
The Fed has tried to stimulate the economy by encouraging the use of HELOCs through low interest rates. If you take out a HELOC to make home renovations, the money you pay the contractor is then used for his or her purchases and helps fuel the economy.