The U.S. Federal Reserve is the most important financial institution within the United States, but according to a study released last year by the Pew Research Center, the U.S. central bank is something of a mystery to Americans.
The Federal Reserve: A riddle, wrapped in a mystery, inside an enigma
Based on Pew's polling, less than a quarter (24%) of respondents correctly identified Janet Yellen as the current chairperson of the Federal Reserve Board. Nearly half volunteered that they didn't know the answer, and 17% selected Alan Greenspan, who's been out of the chairperson position of the Federal Reserve Board for nine years.
In 2013, the Pew Research Center polled Americans to ascertain their knowledge of what the Federal Reserve does, and 73% correctly answered that it "controlled monetary policy;" although this was only after they were given four multiple choice options.
The point here is simple: Far too many people lack the basic knowledge of what the Federal Reserve, also known as the Fed, does, and how it can directly or indirectly affect them and their money. Today, we'll take a look at some of the tools the Fed has at its disposal, as well as the seven ways it can affect you and your wallet.
How the Fed works its magic
As noted above, the Fed's actions revolve around controlling monetary policy, or the overall supply of money within the economy.
In rudimentary form, increasing the money supply can spur economic growth, but it can also lead to inflation, or the rising of prices that consumers like you and I pay for goods and services. If the growth of the money supply slows, it can also slow inflation, or perhaps even lead to deflation. The risk, of course, is that it could also slow economic growth. This is a constant balancing act that the Federal Reserve has to play, and it's why the Federal Reserve Board of Governors meets eight times per year to discuss the latest economic data.
Overall, the Fed works its monetary magic in three ways.
First, it sets the discount rate, or the rate at which banks may borrow from regional Federal Reserve Banks. Just as we, the consumer, feign higher interest rates, so do banks. Thus, a higher discount rate tends to discourage bank borrowing from the Federal Reserve Banks, and thus reduces lending to consumers. A lower discount rate tends to have the opposite effect.
Secondly, the Fed buys and sells U.S. Treasury bonds in an effort to influence the interest rates that we pay on our credit cards or on our mortgage. Because bond prices and bond yields have an inverse relationship, buying U.S. Treasuries increases bond prices (just as bidding up a stock would) while lowering the yield. Selling Treasuries lowers bond prices and boosts yields, and thus interest rates.
Lastly, the Fed regulates the amount of capital that banks need to hold, which is known as the reserve requirement. Having a higher reserve requirement means banks are less likely to lend money, whereas a lower requirement is more likely spur lending and economic growth.
Seven ways the Fed influences your money
Now that we have a better idea of how the Fed utilizes tools at its disposal to affect change on the economy, let's take a closer look at how these changes can affect you and your wallet.
1. Mortgage rates
The interest rate you pay on your mortgage is probably the most well-known way the Fed can affect your pocketbook. Mortgage rates closely follow the yield of 10-year U.S. Treasury bonds, so if the Fed wants to influence rates, all it has to do is adjust the discount rate up or down (remember, a higher discount rate should stifle lending practices among banks), or move its federal funds target rate up or down. Since 2009, the Fed's policy of keeping the federal funds rate target at record low's has allowed homeowners to refinance or purchase homes at some of the lowest interest rates we've seen in decades.
Keep in mind, though, that competition, home supply and demand, and the overall health of the U.S. economy can affect mortgage rates as well.
2. Auto loan rates
Another common way the Fed influences your big purchasing decisions is through the federal funds rate, which is the overnight lending rate that banks charge when lending between one another. The 10 largest U.S. banks collectively set the prime rate, or the lowest rate commercial customers are charged, off of the movement of the federal funds rate.
The federal funds rate, and the prime rate, are also critical in setting auto loan rates. Typically, auto loan rates move up or down in tandem with the prime rate. If the Fed wishes to effect change on the prime rate, it can do so by purchasing or selling short-term U.S. Treasuries. It's worth noting that lender confidence in having loans repaid and the resale value of cars bought with financing also plays into the rate you might pay for your auto loan.
3. Home equity line of credit
If you've paid off a portion of your mortgage and/or your home has increased in value, you may qualify for a home equity line of credit, or HELOC, which you can use to renovate or add onto your home. HELOC rates are similar to auto loans in that they tend to closely follow the movement of the federal funds rate, and thus the prime rate. If the Federal Reserve raises its federal funds target rate, then HELOC rates tend to move up as well. This is why paying attention to what the Fed is suggesting with its federal funds target rate is so important, because if you have a variable rate HELOC, then you could wind up paying more in the upcoming months if the federal funds target rate moves higher.
Consumers will also want to keep in mind that their credit history and score, such as how timely they make their payments, and whether they've maxed out their credit cards or not, could have some bearing on the interest rate they receive with their HELOC.
4. Credit card rates
You're probably noticing a trend by now, but the credit cards in your wallet are intricately tied to the movements of the Fed. Based on the Federal Reserve's movements in short-term U.S. Treasuries, the federal funds rate and the prime rate help lenders determine what they'll charge consumers in interest on their credit card. A rising federal funds target rate should lead to a rising prime rate, and thus a higher interest rate charged to variable rate credit card holders.
As with the above examples, your credit history will play a role in the final interest rate you'll be charged should you carry a balance on your credit card.
5. CD interest rates
Despite the examples above, a rising federal funds rate isn't always a bad thing -- especially if you've got a boatload of money sitting in a savings account. The rate of return on a CD at a bank or credit union is tied to the federal funds rate. If the Fed decides to boost its target rate, which it's been hemming and hawing about for a few months now, CD rates would be expected to rise in tandem, which is good for retirees looking for safe income.
As a reminder, though, investors will want to keep a close eye on the rate of inflation. If the inflation rate is higher than the rate of return on the CD, you'll still be losing "real" money even though you'll be making a nominal profit.
6. The price of goods and services (indirectly)
The Fed's control over the money supply can also have an indirect correlation to the price you pay for everything from a $4,000 couch to a $1.99 stick of butter.
For example, during a recession (and as we witnessed during quantitative easing programs) the Fed may choose to increase the money supply at a more rapid pace than normal to spur lending. This increases the supply of money and it encourages consumers to spend. Increasing the money supply, if the economy is in good shape, can also make it easy for businesses to raise prices, thus leading to inflation. Some inflation is typically optimal, but high levels of inflation would be bad news for the U.S. economy.
Conversely, tightening the expansion of the supply of money can help rein in consumer spending since cash becomes more scarce. It also makes it tougher for businesses to raise their prices.
Ultimately, economic data will determine whether or not we're experiencing inflation or deflation, with the Fed setting its policies based on that data.
7. The job market (indirectly)
Finally, the Fed's ability to make money more available or scarce, as well as its federal funds target rate, work in tandem to indirectly influence the job market.
The Fed's actions, which influence interest rates, can make it more or less attractive for businesses to borrow money. The more attractive the lending rates are, the more likely businesses are to expand and hire more workers. As interest rates rise, the cost of a loan grows more expensive and it makes the prospect of going into debt in order to expand a business less likely.
Now that you have a better understanding of the Federal Reserve, you'll be better prepared when the Board does begin boosting the federal funds target rate, and, more importantly, you'll understand exactly how that move could affect your own bottom line.