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Why you should care about the Fed

By Claes Bell, CFA · Bankrate.com
Friday, January 13, 2012
Posted: 1 pm ET

This week a friend asked me why consumers should care about what the Federal Reserve does.

It's a fair question; there's plenty of economic news a consumer can ignore and pretty much be fine. The beginning of a housing slowdown in China or the stock performance of Apple don't really have that big of an impact on the average American.

But the decisions made by the Fed really do have a pretty strong effect on Americans' wallets. Here are some of the reasons we should pay attention:

  • The Fed's federal funds rate directly affects yields on savings accounts and CDs. Fed rate decisions affect how much it costs banks to borrow money, both on an overnight basis and for longer terms. Because your deposits at banks are pretty much just loans, changes to the federal funds rate are going to affect how much banks are willing to pay you for them.
  • Homebuyers looking to apply for a fixed-rate mortgage and those who hold adjustable-rate mortgages feel Fed rate changes in a big way. While rates on new fixed-rate mortgages don't move in lockstep with the federal funds rate the way, say, short-term CD rates are, they are affected by what investors think Fed rates will be over the term of the loan. Adjustable-rate mortgages are also affected, but because they adjust on a regular basis, ARM-holders feel the influence of the Fed for the life of their loans. It's no coincidence that the sky-high federal funds rates of the early '80s were followed by years of mortgage rates above 10 percent.
  • The prime rate, which moves in lockstep with the federal funds rate set by the Fed, determines the interest rates for most of the variable-rate credit cards in the U.S.
  • The rate of your next auto loan will be determined in part by the Fed's interest-rate moves. Like mortgages, auto loan rates don't really work in lockstep with the federal funds rate, but when the Fed boosts or lowers rates, it definitely affects how much you pay to finance a car.
  • Decisions by the Fed can have a major influence on how hard or easy it is to find a job. When the Fed raises rates and cuts the supply of dollars moving through the country's financial system, the economy slows down. High interest rates mean consumers can't afford to buy as many goods and businesses can't afford to borrow as much to expand. The early '80s again provide a case in point. When then-Fed Chairman Paul Volcker boosted interest rates to fight inflation, millions of people lost their jobs. In 1979, the unemployment rate was around 6 percent; by 1982, it was peaking at 10.8 percent. Of course, the opposite is also true. Had the Fed not cut rates to near zero as the latest recession deepened, unemployment almost certainly would have been even higher than the most recent peak of 10 percent.
  • The Fed influences inflation. They may not be able to put you on a hoverboard or install Mr. Fusion on your car, but if the Fed wanted to, it could make at least part of the famous "Eighties Café" scene from "Back to the Future" come true: Had the Fed never raised rates to fight inflation, the price of a Pepsi could have been on track to hit $50 within your lifetime. Because inflation essentially boils down to too many dollars chasing too few goods, when the Fed raises interest rates and takes money out of the financial system, it slows down inflation.

So if you don't plan on having an auto loan, a mortgage, interest-bearing deposits, a job, a single dollar of American currency, or pretty much any financial product at all, you can safely ignore the Fed. Everyone else, though, might want to check in every once in a while.

Follow me on Twitter: @ClaesBell

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