How interest rate cuts affect consumers

The Federal Reserve’s Open Market Committee (FOMC) meets regularly to decide what, if any, has to do with short-term interest rates. In fact, interest rates are closely watched by analysts and economists because these key data are reflected in every asset market in the world. When the Fed cuts interest rates, stock traders almost always rejoice, but is a rate cut equal to good news for everyone? Interest rate cuts often benefit borrowers, but they hurt lenders and depositors.

But what about ordinary families? Changes in interest rates will also have a significant impact on consumer behavior and economic expectations of consumption levels. This is because higher interest rates translate into higher borrowing and financing costs for items purchased on credit. Read on to understand exactly where this works.

Key points

  • Interest rates have a direct impact on consumer behavior, affecting many aspects of daily life.
  • When interest rates fall, borrowing becomes cheaper, making large amounts of credit purchases more affordable, such as mortgages, auto loans, and credit card fees.
  • When interest rates rise, borrowing costs are higher, which inhibits consumption. However, higher interest rates do benefit those depositors who get more favorable interest rates on their deposit accounts.

What is the interest rate?

When the Fed “cuts interest rates,” this refers to the FOMC’s decision to lower the federal funds target interest rate. The target interest rate is the guideline for the actual interest rate that banks charge each other for overnight reserve loans. The interbank offered interest rate is negotiated and determined by each bank and is usually close to the target interest rate. The target interest rate can also be referred to as the “fed funds rate” or “nominal interest rate.”

The federal funds rate is important because many other domestic and international interest rates are directly or closely related to it.

Why do interest rates change?

The federal funds rate is a monetary policy tool used to achieve the Fed’s price stability (low inflation) and sustainable economic growth goals. Changing the federal funds rate will affect the money supply, starting with banks and eventually permeating consumers.

The Federal Reserve lowered interest rates to stimulate economic growth. Lower financing costs can encourage borrowing and investment. However, when interest rates are too low, they may stimulate excessive growth and even inflation. Inflation will erode purchasing power and may undermine the sustainability of anticipated economic expansion.

On the other hand, when the growth is too fast, the Fed will raise interest rates. The interest rate hike is used to slow inflation and restore growth to a more sustainable level. Interest rates cannot be too high, because more expensive financing may cause the economy to enter a period of slow growth or even contraction.

On August 27, 2020, the Federal Reserve announced that if inflation remains low, it will no longer raise interest rates because the unemployment rate drops below a certain level. It also changed its inflation target to an average level, which means it will allow inflation to be slightly higher than its 2% target to make up for periods of less than 2%.

Financing

The Fed’s target interest rate is the basis for inter-bank lending. The interest rate that the bank charges its most reputable corporate customers is called the prime lending rate. This interest rate is often referred to as the “primary interest rate” and is directly related to the Fed’s target interest rate. Prime is linked to the target interest rate by 300 basis points (3%).

Based on factors such as assets, liabilities, income, and reputation, consumers can expect to pay premium prices plus premiums.

Interest rate cuts can help consumers save money by reducing interest payments on certain types of financing related to preferential interest rates or other interest rates, which are often in sync with the Fed’s target interest rate.

Mortgage

Interest rate cuts can prove beneficial to household financing, but the impact depends on the type of mortgage that consumers have, whether it is fixed or adjustable, and the mortgage interest rate.

For fixed-rate mortgages, the interest rate cut will not affect the monthly payment. Low interest rates may be beneficial to potential homeowners, but fixed-rate mortgages will not directly change with changes in Fed interest rates. The Fed cuts interest rates to change short-term loan interest rates, but most fixed-rate mortgages are based on long-term interest rates, which are not as volatile as short-term interest rates.

Generally speaking, when the Fed cuts interest rates, the payments on Adjustable Rate Mortgage Loans (ARM) will decrease. The amount of change in mortgage payments will depend on the interest rate used when the mortgage is reset. Many ARMs are associated with short-term Treasury yields, which tend to change with the Fed or LIBOR, while the latter does not always change with the Fed. Many home equity loans and home equity lines of credit (HELOC) are also linked to primary or LIBOR.

credit card

The impact of interest rate cuts on credit card debt also depends on whether the credit card has a fixed interest rate or a floating interest rate. For consumers with fixed-rate credit cards, interest rate cuts usually do not bring any change. Many variable rate credit cards are tied to the prime rate, so a reduction in the federal funds rate usually results in lower interest charges.

It is important to remember that even if the credit card interest rate is fixed, the credit card company can change the interest rate at any time, as long as they provide advance notice (check your terms for the required notice).

saving account

When the Fed cuts interest rates, consumers’ savings interest usually decreases. Banks generally lower the interest rate paid for cash held in bank certificates of deposit (CD), money market accounts, and regular savings accounts. It usually takes several weeks for interest rate cuts to be reflected in bank interest rates.

CD and money market accounts

If you have already purchased a bank CD, you don’t need to worry about lowering interest rates because your interest rates are locked in. But if you plan to buy additional CDs, the interest rate cut will result in a new, lower interest rate.

Similar activities will occur for deposits placed in a money market account (MMA). Banks use MMA deposits to invest in traditionally safe assets, such as CDs and Treasury bills, so the Fed’s rate cut will result in lower interest rates for money market account holders.

Money market fund

Unlike money market accounts, money market funds (MMF) are an investment account. Although both pay higher interest rates than ordinary savings accounts, they may react differently to interest rate cuts.

The response of the MMF interest rate to the Fed’s rate cut depends on whether the fund is a taxable fund or a tax-exempt fund (for example, a fund that invests in municipal bonds). Taxable funds usually adjust in line with the Federal Reserve, so if interest rates are cut, consumers can expect these securities to offer lower interest rates.

Because of its tax-exempt status, the interest rate of municipal money market funds is already lower than that of taxable funds and may not necessarily follow the Federal Reserve. These funds may also be linked to different interest rates, such as LIBOR or the Securities Industry and Financial Market Association (SIFMA) Municipal Swap Index.

invest

If you have a 401(k) plan or brokerage account, interest rates will also directly affect your investment portfolio. Lower interest rates usually boost stocks (except perhaps financial sector stocks), but they also drag down bond prices. Lower interest rates also allow investors with margin accounts to gain greater leverage at lower interest rates, thereby increasing their effective purchasing power.

On the other hand, higher interest rates can pull down stocks but increase the value of bonds. Generally speaking, long-term bonds are more sensitive to changes in interest rates than short-term bonds.

Bottom line

The Fed uses its target interest rate as a monetary policy tool, and the impact of changes in the target interest rate depends on whether you are a borrower or a saver. Read the terms of your financing and savings arrangements to determine which interest rates are relevant to you, and to determine what the recent Fed rate cut means to your wallet.

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