- The Federal Reserve on Wednesday is set to lower its benchmark interest rate for the first time since the financial crisis.
- The impact of this rate cut was felt in the housing market and in savings accounts weeks before the Fed’s decision.
- America’s central bank adjusts the interest rates that banks charge to borrow from one another, a cost that is passed on to consumers.
- The Fed raises rates in a strong economy to keep excesses in check, and cuts borrowing costs when the economy needs support.
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Banks give out money all the time – for a fee.
When we borrow and then pay back with interest, it’s how banks make money.
The cost of borrowing, known as the interest rate, can make a big difference in which credit card you choose or whether you decide to get one at all.
But if your bank wants to make it more expensive or cheaper to borrow, it’s not as simple as just slapping on a new rate, as a grocer would with milk prices. It’s a process controlled higher up by the Federal Reserve, America’s central bank.
Why does the Fed care about interest rates?
In 1977, Congress gave the Fed two main tasks: Keep the prices of things Americans buy stable, and create labor-market conditions that provide jobs for all the people who want them.
The Fed has developed a toolkit to achieve these dual goals of inflation and maximum employment. But interest-rate changes make the most headlines, perhaps because they have a real-time effect on how much it costs to borrow.
From Washington, the Fed adjusts interest rates with the hope of spurring all sorts of other changes in the economy. If it wants to encourage consumers to borrow so spending can increase – a boost to economic growth – it cuts rates and makes borrowing cheaper. After the Great Recession, it kept rates near zero to achieve just that.
To accomplish the opposite and cool the economy, it raises rates so an extra credit card seems less desirable.
The Fed often adjusts rates in response to inflation – the increase in prices that occurs when people have more to spend than what’s available to buy.
But for most of this economic recovery, inflation hasn’t really picked up, though it is now well within the Fed’s target range. It’s long been expected to accelerate, especially after the federal government provided a jolt in the form of tax cuts, and as the unemployment rate lingers near its lowest level since 1969.
And so instead of fighting inflation, the Fed now seeks to keep the record-long expansion going for as long as possible. A rate cut on July 31 represents a major milestone in that quest.
How do rates go up or down?
Banks don’t lend only to consumers; they lend to one another as well.
That’s because at the end of every day they need to have a certain amount of capital in their reserves. As regular people with bank accounts spend money, that balance fluctuates, so a bank may need to borrow overnight to meet the minimum capital requirement.
And just as they charge you for a loan, they charge one another.
The Fed tries to influence that charge, called the federal funds rate.
When the fed funds rate falls, banks also lower the rates they charge consumers, so borrowing costs decrease.
Floor and ceiling
After the Great Recession, the Fed bought an unprecedented amount in government bonds, or Treasurys, to inject cash into banks’ accounts. Nearly $2 trillion in excess reserves was accumulated with the Fed. (There was less than $500 billion in 2008.)
The Fed decided that one way to pare down this stockpile of Treasurys was to lend some to money-market mutual funds and other dealers. It does this in transactions known as reverse repurchase operations, which involve selling the Treasurys and agreeing to buy them back the next day.
The Fed sets a lower “floor” rate on these so-called repos.
Then it sets a higher rate that controls how much it pays banks to hold their cash, known as interest on excess reserves. This acts as a ceiling, since banks won’t want to lend to one another at a rate lower than what the Fed is paying them – at least in theory.
For example, when the Fed raised rates last September, it set the repo rate at 2% and the interest on excess reserves at 2.25%, the highest range in more than a decade.
The effective fed funds rate, which is what banks use to lend to one another, then floated between a target range of 2% and 2.25%.
When the Fed raises rates, banks are less incentivized to lend, since they are earning more to park their cash in reserves.
The impact of rate decisions
After the Fed lifts or cuts the fed funds rate, the baton is passed to banks.
After a rate hike, banks raise the rate they charge their most creditworthy clients – such as large corporations – known as the prime rate. Usually, banks announce this hike within days of the Fed’s announcement.
Things like mortgages and credit-card rates are then benchmarked against the prime rate.
But the impact of higher or lower rates can be felt long before the Fed acts if the policy decision is considered a certainty. In the second quarter of 2019, for example, the 30-year mortgage rate fell below 4% as traders speculated on a rate cut. This drop triggered a boom in refinancing and purchases, The Wall Street Journal reported.
There hasn’t been as much fanfare for savers. Some online banks including Ally and Marcus by Goldman Sachs lowered their savings-accounts rates in advance of the Fed’s decision, according to Bankrate.
But that shouldn’t make you panic.
“While the Fed stands ready to cut rates at future meetings if needed, for consumers all that will do is unwind a fraction of the nine rate hikes enacted since 2015,” said Greg McBride, the chief financial analyst at Bankrate, in a statement.
“It will not unleash any measurable spending power, and would be more of a move to sway market sentiment – and perhaps favor within the White House.”
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