Seven Ways Fed Policy Affects Your Pocketbook

Published August 26, 2011

| Bankrate.com

When the Federal Open Market Committee meets to set the federal funds rate, the decision has far-reaching effects on almost every aspect of your personal finances and household wealth.

From the interest rate you pay on debt to the availability of credit and even your prospects in the job market, they all can be traced back to the projections and judgments of Federal Reserve Board Chairman Ben Bernanke and the other FOMC members -- Fed board governors and reserve bank presidents -- who meet in Washington to decide on the central bank's monetary policy.

"The decisions of the Fed impact, literally, every financial decision you make," says Michael Reese, a Certified Financial Planner in Traverse City, Mich. "The Federal Reserve has its fingers in your pocketbook to a greater degree than the IRS."

The Fed's mission is to encourage as much economic growth as possible without raising inflation. "The Fed has a dual mandate. They want to have low and steady inflation and a strong labor market," says Gus Faucher, director of macroeconomics at Moody's Analytics.

Inside the Fed's Toolbox

The Fed has three ways of influencing the federal funds rate, which is the rate at which banks lend to each other overnight and is used as the benchmark for a range of consumer interest rates.

  • It buys Treasury securities from the market to shrink the supply of government debt, thereby increasing the price and bringing down the interest rate on the securities. (Or, it sells Treasuries into the market to increase the supply, lower the price and raise interest rates.)
  • It sets the discount rate, which is the rate at which banks may borrow from regional Federal Reserve Banks. If the discount rate is raised, banks bear higher borrowing costs and tend to curb their lending, boosting interest rates. If it's lowered, banks generally make credit more widely available and rates fall.
  • It establishes reserve requirements, or the amount of capital banks must hold as security for the deposits on their books. If reserve requirements are increased, banks tend to reduce their lending activity; if they're loosened, banks make loans more freely

Making Credit Available

 

In addition to the rate, the Fed's actions influence the availability of credit. When the Fed is boosting the money supply -- for instance, by buying government bonds from the market -- lenders are more willing to extend credit.

At the eight regularly scheduled FOMC meetings a year, committee members decide how many securities to buy and at which maturities, after they pore over data and reports from across the country on the labor market, inflation and gross domestic product, a key indicator of the economy's output and health.

The committee then unveils their new target range for the federal funds rate, currently zero percent to 0.25 percent, and shares their projections in an announcement closely watched by traders and policymakers around the world. Within seconds, financial markets begin to adjust, affecting your pocketbook in the following seven ways.

Prices You Pay

The Fed's actions indirectly influence 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.

"It's still very difficult for firms to raise prices in the current environment," says Faucher. "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."

It's easier to stop inflation than it is to break out of a deflationary cycle, says Ara Oghoorian, a CFP in Los Angeles who previously worked for the Fed as a bank examiner.

Recently, the Fed grew concerned about possible deflation -- a cycle of falling prices that is very damaging to the economy -- and lowered interest rates in order to actually bring the inflation rate closer to the 2 percent or 2.5 percent that is considered healthy.

The Fed most wants to prevent a repeat of the "lost decade" of stagnant economic growth in Japan when prices fell, people delayed purchases in hopes of cheaper prices, and that caused prices to fall even further.

The Job Market

You probably never thought of the Fed the last time you updated your resume. But the Fed is thinking of you. At every meeting, the FOMC considers labor market data as they make decisions aimed at lowering the unemployment rate to about 5.5 percent or 6 percent. They look at numbers such as payroll changes, hiring, the labor force participation rate and duration of unemployment.

The Fed can only indirectly affect the job market, by lowering interest rates to encourage more borrowing. That prompts businesses to take out loans to purchase new machinery or invest in new equipment and encourages consumers to borrow in order to buy goods and services, Faucher says.

"That increases aggregate demand. Then businesses are producing more and they need to hire more workers," he says. "That in turn leads to a better labor market and lower unemployment rate."

Credit Card Rates

The majority of credit cards charge variable interest rates tied to an index, usually the prime rate, which is 3 percentage points above the federal funds rate. When the federal funds rate changes, the prime rate does as well and thus, 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. "They keep interest rates low in an effort to boost economic growth."

When the Fed sets a low rate, you are encouraged to borrow to buy a new appliance, make home repairs or conduct similar purchases that stimulate the economy. Of course, the annual percentage rate you pay on your credit card can rise for other reasons, such as late payments or the end of a low introductory rate.

Certificates of Deposit

If you rely on interest from certificates of deposit for income, you're probably not too happy with the Fed keeping interest rates at rock bottom. "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 set by 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, a financial consultant at Charles Schwab. In the late '80s, 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.

You should seek to maximize the total return of your portfolio, not just the income. Recognize that the Fed's actions are intended to prompt you to invest in higher-yielding bonds and stocks, thereby fueling the economy. "There's an old adage, 'Don't fight the Fed,'" Mervine says. "When the Fed can keep you from earning anything in safe money, you really have to take some measured risk."

Auto Loans

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 parallel with the federal funds rate.

If a given bank is charging its customers 5.64 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 6.14 percent. Auto loans also benefit from being sold into the secondary market, making more investors' dollars available to finance your car purchase or refinancing.

Home Mortgages

When the Fed lowers the federal funds rate, lenders can finance home loans more cheaply. As a result, they can reduce the interest rates they charge you for a fixed-rate mortgage. In recent years, the federal funds rate has been zero or near zero, as the Fed attempts to stimulate the housing market.

"The Fed is making homes affordable at all-time levels with low interest rates on mortgages," Mervine says. "A lot of people are underwater, but if they can save and pay down their prior mortgage, they can refinance at extremely low rates."

The Fed can even control the shape of the yield curve, or the relation between interest charged for one-year loans, three-year loans, five-year loans and so on. "If they want to bring down 10-year rates, they'll go out and buy 10-year securities," says Oghoorian.

Mortgages are pegged to the 10-year Treasury rate, because refinancings and early payoffs effectively give the 30-year mortgage a 10-year duration, Oghoorian says. Competition and market conditions also affect rates.

Home Equity Lines

Also directly tied to the federal funds rate: your home equity line of credit, or HELOC. That's because HELOC rates are typically linked to the prime rate. When the Fed raises or lowers its target rate, HELOC rates follow suit.

"It's a great time to refinance or restructure your debt, if you've got home equity that you can use to consolidate high-interest credit card debt or other less accommodative types of debts," Mervine says.

By encouraging the use of HELOCs through low interest rates, the Fed is also trying to stimulate the economy. If you take out a HELOC to make home renovations, the money you pay the contractor is then used for his or her purchases and fuels the economy.

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