When the Federal Reserve raises or lowers interest rates, you feel it.
“The Federal Reserve has its fingers in your pocketbook to a greater degree than the IRS,” says Michael Reese, a certified financial planner in Traverse City, Michigan.
The committee sets monetary policy, primarily by raising or lowering the Fed’s target for the federal funds rate, which is used as the benchmark for a range of consumer interest rates.
The committee held its fourth meeting of 2019 on June 18-19. The Fed held rates steady, and forecasts show there could be a rate cut at some point this year.
Here are seven ways the Fed affects your pocketbook.
1. The Fed influences prices
The Fed’s actions have an indirect 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,” says Gus Faucher, chief economist with The PNC Financial Services Group.
Traditionally, the Fed fights inflation by raising the federal funds rate, which makes money more expensive and scarcer. That is supposed to reduce overall demand and slow the pace of price increases. Raising the federal funds rate is less about fighting inflation and more about getting the rate closer to its long-term neutral of 3 percent to 3.5 percent, says Joel Naroff, president and chief economist for Naroff Economic Advisors.
2. The Fed affects jobs and wages
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 indirectly affects the job market. When it raises the federal funds rate, it tends to slow the economy. That leads to fewer people being hired. They also have less leeway to demand pay raises. This lack of power to bargain for higher wages is seen as a way to fight inflation.
3. Fed affects credit card rates
Most credit cards charge variable interest rates tied to 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 sends credit card rates higher, it costs more to borrow. So people tend to borrow less, and buy less. That slows the economy and puts the brakes on inflation.
4. Fed nudges CD yields
If you rely on interest from certificates of deposit for income, you’re probably not happy that the Fed kept interest rates at rock bottom for so long.
“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, vice president and 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.
5. Fed drives auto loan rates
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 percent 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 percent. Auto loans also benefit from being sold into the secondary market, making more investors’ dollars available to finance your car purchase or refinancing.
6. Little influence on mortgages
Mortgage rates respond to market forces — specifically, to the needs of bond investors. The Federal Reserve exerts an indirect influence on mortgages.
Sometimes mortgage rates go up when the Fed increases short-term rates, as the central bank’s action sets the tone for most other interest rates. But sometimes mortgage rates fall after the Fed raises the federal funds rate. Look at the last time the central bank went on an extended rate-raising campaign.
Starting in June 2004, the Fed raised the federal funds rate 17 times in two years. And what happened at first? Mortgage rates fell during the summer and fall of 2004. Back then, the Fed’s rate hikes caused investors to become less concerned about inflation, so mortgage rates fell.
Mortgage rates eventually rose, and were higher in June 2006, at the end of the rate-hiking campaign, than they were at the beginning, two years earlier.
In 2017, housing economists predicted mortgage rates would rise. Instead, they remained fairly steady despite three Fed rate hikes. But mortgage rates spent much of 2018 on a steady climb before dipping slightly in December, which shows the central bank’s actions aren’t predictive.
7. Touching home equity lines
Your home equity line of credit, or HELOC, is linked to the prime rate. When the Fed raises its target rate, HELOC rates follow.
Because credit card interest rates will go up, too, it still could be to your advantage to consolidate credit card debt into a lower-rate HELOC if you have the self-discipline to pay off the debt as quickly as you can.
The sooner you pay off variable-rate debt, the better, because many investors and economists expect the Fed to keep gradually increasing the federal funds rate.