How the Fed impacts rates

We get a lot of questions about the role of the Federal Reserve in interest rates. These questions range in specificity and are often influenced by the high volume of headlines speculating about what the Fed will do next or analyzing its role in the stock market and economy.

With the Central Bank forecasting a number of rate hikes in 2022, now is a good chance to go over how the Fed influences interest rates, including how the elusive “fed funds rate” works.

A bit about banking

To understand how the Federal Reserve influences rates, it’s important to understand our banking system at a high level. 

The law requires banks to keep a certain amount of customer money on hand, or in reserve, each night.  Because banks don’t generate revenue on their reserves, they try to keep as close to the minimum as possible. This means banks sometimes dip below their reserve requirement. When that happens, a bank will borrow money from other banks in the form of overnight loans. The banks charge each other interest on these overnight loans, and the Federal Reserve sets a target for what this rate should be. It bases this target rate, known as the federal funds rate, on its assessment of the economy, and banks stick to it closely. 

When the federal funds rate increases, it’s more expensive for banks to borrow money, which tends to set off a domino-style series of events: Banks want to avoid paying the higher overnight interest, so they tend to keep more money in their reserves. Banks need more incentive to lend their money out, even to their most creditworthy customers. This rate — the rate charged to the most creditworthy customers — is known as the prime rate. The prime rate affects everything from mortgage rates to how much interest you earn on a savings account.

The converse is also true. When the federal funds rate goes down, banks don’t have to worry as much about keeping cash on hand. They’re more inclined to lend money to consumers, and they tend to offer better rates to borrowers.

This is not the only way the Federal Reserve can influence interest rates and encourage banks to lend, but it tends to be the most common and generally has the biggest impact on consumers and investors.

The inflation effect

It can be easy to get caught up in the many ways the Federal Reserve influences interest rates, but it’s important to take a step back and remember that interest rates themselves are just a tool for the Fed. 

The Federal Reserve’s primary job description is to encourage maximum employment and stable prices. In other words, it has a dual mandate to encourage hiring and prevent inflation. To do so, the Fed looks at overall economic trends and market factors.

For more than a decade following the Financial Crisis, the Fed focused largely on jobs. They cut interest rates to historical lows (essentially, zero) during the Great Recession to make it easier for companies to borrow money. The goal was to give companies more capital to hire employees. The Fed used more tools than just lowering interest rates, however, engaging in other tactics to increase the amount of money moving through the economy, including quantitative easing (QE). 

Putting more money in circulation led many economists to worry about inflation. However, despite these concerns emerging during the Financial Crisis and extending throughout the period of historically low-interest rates, government data showed prices increasing at a standard rate — around 2-3% per year — until COVID-19. 

The pandemic led to big shifts in commodity prices and global commerce, causing inflation to quickly move from a hypothetical discussion among economists to a real concern for regular people. The Federal Reserve took note and announced several rate hikes in 2022 in an attempt to rein in inflation.

Fed watching

Announcing rate hikes ahead of time may seem strange if you’ve been paying attention to Fed policy for any length of time. Prior to 2008, the Fed didn’t announce its intentions in advance. That changed during the Financial Crisis in an effort to avoid spooking markets. Often, the stock market goes up on news of a rate cut, since investors tend to link easier borrowing with greater profitability. Now, however, the reactions are more complex. The market may react one way when a rate change is announced (or even on the rumor of an announcement) and not at all when the change actually takes effect. 

We mention this mainly because the anticipation, forecasting, and wide range of reactions tend to create a high volume of headlines about the Federal Reserve and interest rates. And that attention can generate confusion for clients, who wonder what’s actually happening and what it means for them.

That’s one of the reasons we watch the Federal Reserve closely, so we can zero in on the biggest news and update client financial plans accordingly. 

We’re also looking beyond the United States since the economy is global now. When we look at countries similar to the U.S., i.e., developed countries where the population is aging, we see a tendency to keep interest rates low. This suggests that in the long run, interest rates are likely to remain low. In the short term, however, we know the Fed’s priority is going to be living up to its mandate and getting inflation in check. 

When it comes to client investments, we always take the Federal Reserve and interest rates into account. We also look beyond what the Fed is saying and doing and look closely at the economy and markets — the same factors the Fed itself watches. Those observations, along with client goals and circumstances, help us make key decisions when managing portfolios.

Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual.