The Fed Giveth, and the Fed Taketh Away
The Federal Reserve can help or hurt your finances in a matter of minutes, depending on what it says and does.
Interest rates on credit cards, mortgages and auto loans are at stake each time Fed members meet to set the key federal funds rate. Even your chances of getting a loan at all can be affected by what happens at Federal Open Market Committee meetings.
The Fed doesn't control consumer rates directly, but it sets the federal funds rate, which is what banks pay to borrow money from one another. In theory, when the federal funds rate is low, banks have more money available to lend, and consumers can borrow at lower costs.
The Fed has kept the federal funds rate near zero percent since the financial crisis in 2008, but it can't keep it at the bottom forever.
The Fed may influence your finances even when the federal funds rate is left unchanged. That's because investors pay close attention to what Fed members say, including their perspective on the economy and plans for new monetary policy. Here is a closer look at how much power the Fed has over your financial life.
The Federal Funds Rate and Mortgage Rates
Mortgage rates are dictated mostly by market movements, but the Fed can have a huge influence on rates.
Even though the federal funds rate is not tied to mortgage rates, it affects them indirectly because it impacts lenders' borrowing costs.
"If it is more expensive for banks to borrow, they will pass that expense on to their customers," says Brett Sinnott, director of secondary marketing at CMG Mortgage Group in San Ramon, Calif. "In the current environment, any change will have a direct, instant and negative impact on rates."
The Fed also uses monetary stimulus programs, such as bond purchases, to help keep mortgage rates where it wants them.
When the Fed buys mortgage bonds and U.S. Treasuries, it increases demand for these investments. Such purchases tend to keep mortgage rates down. In the other direction, The Fed can decrease demand by selling bonds, which could send mortgage rates up.
The Fed's economic projections also influence mortgage rates, as they affect investors' sentiments. A gloomy economic outlook usually means lower mortgage rates. Signs of a stronger economy often result in higher mortgage rates.
The Federal Funds Rate and Auto Loan Rates
Seeing great deals on auto loan rates? Don't bother calling Federal Reserve Chairman Ben Bernanke to say thanks.
As with most consumer loans, auto loans are profoundly affected by Federal Reserve policy, but unlike credit cards or home equity lines of credit, auto loan rates don't move in lock step with the federal funds rate, says Paul Taylor, chief economist at the National Automobile Dealers Association.
Instead, the Fed influences rates mostly through the buying and selling of short-term Treasuries on the open market, Taylor says. When the Fed buys Treasuries, rates on loans of similar maturities fall. To that end, the Fed has been buying Treasuries in the last few years to drive down rates.
But the rates you'll ultimately see at the auto dealership aren't just reflective of Fed policy. They're also influenced by a complex cocktail of market forces, including the market's confidence that auto loans will get paid back, the resale value of used cars in case they don't and expectations about where inflation is headed, he says. All of those are pointed in borrowers' favor right now.
"You know how people will talk about certain times when the stars are aligned? Well that's sort of how the economic variables have lined up during this recession," he says.
The Federal Funds Rate and CD Rates
Rates on certificates of deposit follow the federal funds rate nearly exactly. When the Federal Open Market Committee raises or lowers the federal funds rate, CD rates follow.
There has been at least one recent occurrence of the opposite, when CD rates increased before the federal funds rate.
"In August 2003, the (federal) funds rate was 1.25%, and the national average for CDs was 1.91%. The Fed kept the funds rate flat until June 2004. For 10 months, it was unchanged, yet the market moved interest rates independently, so the average of CDs went up to 2.25%, and only after June 2004 did the Fed increase the funds rate," says Dan Geller, executive vice president of Market Rates Insight, a pricing consultant to financial institutions.
Geller says that could happen again this year if businesses begin to borrow as the economy expands. "It's possible because there is a precedent," he says.
To find the sweet spot for CD rates, banks use the overnight rate as their benchmark and turn the dial on CD and savings account rates to fit loan demand. When there is a higher demand for loans, CD rates increase but not too much. For loans to be profitable, banks leave a cushion between the rates paid on deposits and the interest charged for loans, called the net interest spread.
The Federal Funds Rate and the Prime Rate
Interest rates on variable-rate credit cards and home equity lines of credit are based on the prime rate, a consensus rate from the 10 largest U.S. banks. Commercial banks use it to make loans to their most creditworthy customers.
The prime rate, which is tied to the federal funds rate, is published by The Wall Street Journal and changes when seven of the 10 banks change their rates.
Lenders will add a margin to the prime rate, such as 2 percentage points, to determine the interest rate a consumer will pay on credit cards or HELOCs, says Keith Leggett, senior economist at the American Bankers Association in Washington, D.C.
However, a consumer's credit score and history also help determine an interest rate. A consumer with a higher credit score and a better payment history likely will receive a lower interest rate, while someone with a lower score and blotchy payment past will get a higher rate.