The Federal Open Market Committee (FOMC) of the Federal Reserve, composed of the seven members of the Board of Governors and five Federal Reserve Bank presidents, meets eight times a year in Washington, D.C., to set monetary policy including setting the federal funds interest rate. The two-day meetings conclude with a statement by the Federal Reserve chair, currently Kevin Warsh, with action on interest rates often a key focus of Wall Street speculation and the business media’s reporting.
There is a good reason for this focus: interest rates help determine both the cost of borrowing money and the reward for saving money. Interest rate fluctuations are a normal part of the economic cycle, affecting savings and investments. Higher, lower or static interest rates have a ripple effect throughout the economy, including on investments.
How interest works
Interest can refer to both the cost of borrowing money and the return earned on an investment. When money is borrowed from a financial institution, the borrower is obtaining a loan in exchange for a small fee, which is the interest paid to the financial institution. When investing money in a savings account, bond, or other money market product, interest is the return received on that investment.
Short-term and long-term interest rates are based on the timeframe of a loan or investment. Short-term interest rates apply to savings accounts, money market accounts, and certificates of deposit (CDs) with curtailed time frames. Short-term rates are generally influenced by central bank policies and economic conditions at the time the rates are set. These rates are thus typically lower than long-term interest rates but more sensitive to short-term fluctuations.
Long-term interest rates apply to loans and investments with extended borrowing periods, such as long-term bonds (10-plus years) and 30-year fixed rate mortgages. Long-term rates are influenced by the economic outlook and inflation expectations, among other factors. These rates are usually higher than short-term interest rates to make up for the potential of greater risk over time.
Treasury yields span multiple timeframes. The Fed’s decisions on rates ultimately steer the prime rate, which can have an impact on consumer debt (such as variable-rate credit cards). Treasury yields can reach multiyear highs, which rattle some investors. Because bond yields and prices have an inverse relationship, when bonds yields are higher, the effects can be felt across the financial spectrum, from investing in stocks and bonds to borrowing costs and savings returns.
Why the Fed’s rate decisions matter
The Federal Reserve works with short-term rates. The federal funds rate, which the central bank sets, is the interest rate at which banks borrow and lend to one another overnight. Although consumers do not pay that rate directly, changes to the federal funds rate reverberate through the economy, affecting many borrowing and savings rates.
Generally, shorter-term rates on consumer debt are closely pegged to the prime rate, which is typically three percentage points above the federal funds rate. Longer-term rates are more dependent on inflation expectations and other economic factors.
When the Fed raises its benchmark rate, it effectively increases the cost of money throughout the financial system. Borrowing becomes more expensive for consumers and businesses. Consumers face higher costs for mortgages, car loans, and credit card debt, among other financial products.
The result is that loans become more expensive, making consumers and businesses less likely to borrow and spend. This slowdown in demand helps reduce inflationary pressures. On the flip side, higher interest rates also mean savers may earn more money on their deposits.
The Fed raises rates with the intention of slowing economic activity enough to bring inflation under control. While that can help stabilize prices, it can also create challenges for businesses and consumers. Higher borrowing costs can discourage business investment and expansion. Companies may delay projects, reduce hiring plans, or become more cautious about growth initiatives. For consumers, this can translate into slower wage growth and fewer job opportunities. These effects tend to occur gradually and often take months or even years to fully materialize.
How interest rates can affect you
The most obvious impact of the Fed’s rate decisions is on borrowing. For example, if you recently said “yes” to an adjustable rate for a loan product, higher interest rates will impact the long-term cost of borrowing to purchase the item. Most credit cards have a variable rate, so there is a direct connection to the Fed’s benchmark.
As the federal funds rate rises, the prime rate does, as well, and credit card rates follow suit within one or two billing cycles. However, credit card borrowers will likely feel the increase quickly. A quarter-point hike of 0.25% would add about $1.38 a month in interest on average $6,600 card balance, according to Charlie Wise, head of global research at the Illinois-based credit reporting bureau TransUnion.
If you are looking to apply for a new loan, the results will be influenced by current interest rates. A rate hike can push the prime rate up, increasing borrowing costs for many types of consumer loans. Rates for auto loans, which tend to follow longer-term market rates, are unlikely to be significantly affected by occasional rate hikes. Even if lenders pass along the full quarter-point increase, Cox Automotive estimates it would add about $6 a month to a new-car payment and $4 to a used-car payment. However, a series of rate increases would be more consequential.
Mortgage rates are tied to the 10-year Treasury yield rather than the shorter-term federal funds rate. That is because most 30-year mortgages last around 10 years before being refinanced or exited through a sale. When the yield on the 10-year Treasury note topped 5.3% in early October, the highest level since 2002, the average interest rate on the 30-year fixed mortgage surpassed 7% for the first time in over a year.
The push into what is widely viewed by economists as a worrisome threshold came as surging oil prices, sparked by the ongoing Iran War, battered government bonds across the globe. The rising yield was also caused in part by mounting public debts and blockbuster debt issuance by tech “hyperscalers” firms financing the artificial intelligence (AI) boom.
Higher interest rates are not all bad news. On the upside, the interest rates on savings accounts may move higher. Higher Fed rates generally lead to higher yields on high-yield savings accounts, money market funds, CDs, and short-term Treasury securities. Savers can benefit from earning more interest on their cash.
Conclusion: Ride the waves
Rising interest rates can be frustrating if you are looking to make specific spending choices, but it is important to remember that interest rates are always changing. What goes up will eventually come down. In the meantime, borrowers can focus on maintaining good credit, adjusting budgets, and considering alternate ways to reach financial goals.
For those with money invested in the stock market, rising interest rates may have an impact on your investments, at least in the short term, due to related market fluctuations. When interest rates go up, so do concerns about the health of the economy. Work with a financial adviser to assist you with any questions or concerns that you may have about your investments.
As always, if you have any questions about this report or any other questions, please reach out to Bowen Asset at info@bowenasset.com or (610) 793-1001.
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