How Federal Reserve Interest Rate Cuts Affect Consumers

The Federal Reserve’s Open Market Committee (FOMC) meets eight times per year to decide what to do with short-term interest rates, if anything. Interest rates are closely watched by analysts and economists because these key figures play out in every asset market around the globe. Stock traders almost always rejoice when the Fed cuts rates but does a rate cut equal good news for everyone? Rate cuts tend to favor borrowers but they hurt lenders and savers.

Interest rate changes also have large impacts on consumer behavior and the level of consumption that an economy can expect. Higher rates translate to larger borrowing and financing costs for purchases made on credit.

Key Takeaways

• Interest rates have a direct effect on consumer behavior, impacting several facets of everyday life.
• Borrowing becomes cheaper when rates go down, making large purchases such as home mortgages and auto loans on credit more affordable.
• Borrowing is more expensive when rates go up, putting a damper on consumption.
• Higher rates do benefit savers who get more favorable interest on deposit accounts.

What Is the Federal Funds Rate?

It refers to a decision by the FOMC to reduce the federal fund’s target rate when the Fed “cuts rates.” The target rate is a guideline for the actual rate that banks charge each other on overnight reserve loans. Rates on interbank loans are negotiated by the individual banks and they usually stay close to the target rate. The target rate may also be referred to as the “federal funds rate” or the “nominal rate.”

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

Why Do Rates Change?

The federal funds rate is a monetary policy tool used to achieve the Fed’s goals of price stability or low inflation and sustainable economic growth. Changes to the federal funds rate influence the money supply, beginning with banks and eventually trickling down to consumers.

The Fed lowers interest rates to stimulate economic growth. Lower financing costs can encourage borrowing and investing but rates can spur excessive growth and perhaps inflation when they’re too low. Inflation eats away at purchasing power and can potentially undermine the sustainability of the desired economic expansion.

The Fed will raise interest rates when there’s too much growth. Rate increases are used to slow inflation and return growth to more sustainable levels. Rates can’t get too high because more expensive financing can lead the economy into a period of slow growth or even contraction.

2%

The target inflation rate that the Federal Reserve seeks to achieve.

Financing

The Fed’s target rate is the basis for bank-to-bank lending. The rate that banks charge their most creditworthy corporate customers is known as the prime lending rate. It’s linked directly to the Federal Reserve’s target rate and is often referred to as simply “the prime.”

Consumers can expect to pay prime plus a premium depending on factors such as their assets, liabilities, income, and creditworthiness.

A rate cut could help consumers save money by reducing interest payments on certain types of financing that are linked to prime or other rates that tend to move in tandem with the Fed’s target rate.

Mortgages

A rate cut typically lowers the cost of financing a home but the extent of the benefit from lower mortgage rates depends on the type of mortgage loan.

A rate cut will have no impact on the amount of the monthly payment for a fixed-rate mortgage. Low rates can be good for potential homeowners but fixed-rate mortgages don’t move directly with the Fed’s rate changes. A Fed rate cut changes the short-term lending rate but most fixed-rate mortgages are based on long-term rates that don’t fluctuate as much as short-term rates.

Adjustable-rate mortgage (ARM) payments will generally decrease when the Fed issues a rate cut. The amount by which a mortgage payment changes will depend on the rate the lender uses when it resets. Many ARMs are linked to short-term Treasury yields that tend to move with the Fed. Many home-equity loans and home-equity lines of credit (HELOCs) are also linked to prime or LIBOR.

Important

The FOMC decreased interest rates by 0.50% to 4.75% to 5% in September 2024 based in part on progress made against inflation.

Credit Cards

The impact of a rate cut on credit card debt also depends on whether the credit card carries a fixed or variable rate. A rate cut usually results in no change for consumers with fixed-rate cards. Many credit cards with variable rates are linked to the prime rate so a federal funds rate cut will typically lead to lower interest charges.

Credit card companies can change interest rates whenever they want to even if a credit card carries a fixed rate as long as they provide advance notice.

Savings Accounts

Consumers usually earn less interest on their savings when the Fed cuts interest rates. Banks will typically lower rates paid on cash held in bank certificates of deposits (CDs), money market accounts, and savings accounts. It usually takes a few weeks for the rate cut to be reflected in bank rates.

CDs and Money Market Accounts

There’s no need to worry about a rate cut if you’ve already purchased a bank CD because your rate is locked in. A rate cut will result in lower rates. if you plan to purchase additional CDs, however.

Deposits placed into money market accounts (MMAs) will see similar activity. Banks use MMA deposits to invest in traditionally safe assets like CDs and Treasury bills so a Fed rate cut will result in lower rates for money market account holders.

Money Market Funds

A money market fund (MMF) is an investment account, unlike a money market account. Both pay higher rates than regular savings accounts but they may not have the same response to a rate cut.

The response of MMF rates to a rate cut by the Fed depends on whether the fund is taxable or tax-free such as one that invests in municipal bonds. Taxable funds usually adjust in line with the Fed so consumers can expect to see lower rates offered by these securities in the event of a rate cut.

Rates on municipal money market funds already fall beneath their taxable counterparts because of their tax-exempt status and they may not necessarily follow the Fed. These funds may also be linked to rates such as LIBOR or the Security Industry and Financial Markets Association (SIFMA) Municipal Swap Index.

Investments

Interest rates also directly impact your investment portfolio including a 401(k) plan and brokerage accounts. Lower rates are often a boost to stocks except perhaps financial sector stocks but they’re a drag on bond prices. Lower rates also let investors with margin accounts take greater advantage of leverage at lower rates, increasing their effective purchasing power.

Higher rates can pull stocks lower but increase the value of bonds, however. Longer-term bonds are generally more sensitive to interest rate changes than near-term bonds.

How Do Interest Rates Affect Consumers?

Higher interest rates generally make the cost of goods and services more expensive for consumers because the cost of borrowing to purchase them is higher. Consumers who want to buy products such as a house or a car that require loans will pay more because of the higher interest rate on the loans. This discourages spending and slows down the economy. The opposite is true when interest rates are lower.

Who Benefits From High Interest Rates?

Financial institutions and specifically banks generally benefit from higher interest rates. Banks make money from the rates they charge on their loans to consumers. The higher the rate, the more money they make.

Who Benefits From Inflation?

Borrowers benefit the most from inflation as the money they pay back to lenders is worth less than it was before. This is the case provided that wages are also increasing for the borrower.

The Bottom Line

The Federal Reserve uses its target rate as a monetary policy tool and the impact of a change to the target rate depends on whether you’re a borrower or a saver. It’s important to read the terms of your financing and savings agreements to determine which interest rates apply to you and determine how a Fed cut can impact your financial situation.

Read the original article on Investopedia.