On Wednesday, March 21, the Federal Reserve raised its key interest rate from 1.5% to 1.75% as they continue to tighten monetary policy and the economy continues to improve from the depths of the Great Recession.
What is the Federal Reserve?
The Federal Reserve (the Fed) is the central bank of the United States. It was created in 1913 and is tasked with the main goals of price stability, full employment, bank regulation and supervision as well as maintaining the stability of the financial system. To accomplish these ends the Fed has control over the Federal Funds Rate which is the rate that banks can lend to each other. In determining this rate, the Fed tries to ensure economic conditions are just right (much like Goldilocks and the 3 Bears). If the economy is weak, the Fed will lower rates which reduces the costs to borrow for both consumers and corporations to goose spending and improve the economy. While the cost to borrow drops, so does the savings rate which creates a disincentive to save and hopefully a preference to consume. On the other hand, if the economy is strong (as it is now, or at least getting there) the Fed will raise rates thus increasing the cost for consumers and corporations to borrow to keep the economy from overheating and to stave off inflation. Just like when rates drop, a rising rate impacts savings rates, this time increasing the amounts that the bank will pay for your deposits and creating an incentive for savers to save and a disincentive to spend.
What does this mean to me?
It is important to understand that this rate only directly impacts banks. Neither the consumer nor the corporation can borrow at these rates directly, however, it does impact consumer and corporate rates indirectly. Think of it as a foundational rate that other rates derive their value from. The items that should see the most direct effect are:
1) Variable rate loans – This includes the rates on credit cards, adjustable rate mortgages (ARMs) and home equity lines of credit. As interest rates begin to rise, the rates on these loans should also rise, making these forms of debt costlier to the consumer.
2) Auto loan rates -. As auto loans tend to be shorter in their maturity, they are more closely impacted by short-term rate increases. As with variable rate loans, the rates charged should increase but it may not have a material impact on the difference in monthly payments.
3) Savings rates -. At least, in theory, the rates that are paid by the bank in short-term savings accounts as well as CDs should begin to rise. This will be a welcome sight for savers who have been starved for yield. In fact, short-term bond rates offer a positive real yield for the first time since the financial crisis.
What about fixed mortgage rates and student loans?
These are both longer term fixed rate loans that more closely track the yield on the 10-year treasury note. While the Fed Funds Rate is a foundational rate and plays a part in determining the yield on these bonds, they tend not to be as highly correlated as short-term rates are (see variable rate loans). The 10-year will tend to generally follow the direction of the Fed Funds Rate albeit not directly. In short, these rates should begin to rise but it should be gradual in nature and should not make an immediate impact on the cost to borrow for longer dated fixed rate loans like mortgages and student loans.
What should I do?
It is important to keep in perspective that rates are still relatively low by historical measures and that there is certainly no need to rush out to buy a home or a car. Money will continue to become more expensive and if you are on the fence with either of these purchases, you may want to consider making a move sooner rather than later. It may also be time to take advantage of those 0% interest credit cards if you tend to carry a balance. Use the 0% period to try and eliminate those balances as the increased interest rates will make the purchases you made even more expensive than they already are. Finally, if you have an adjustable rate mortgage it may be time to consider locking in rates with a 15 or 30-year fixed rate loan.