By now, you have probably heard that the Federal Reserve chose on Tuesday to leave the federal funds interest rate unchanged after having made 17 consecutive increases over the past two years. The Federal Reserve itself suggested at its previous meeting the possibility that it might choose to pause in its series of tightening moves, with the explanation that it wanted to examine more closely the effects of its actions. Since some effects of interest-rate changes become apparent only after a period of time has passed, this explanation allayed some observers' concerns that the Fed would go too far and create a restrictive economic environment that could cause a recession.
Perhaps the most confusing thing about Fed announcements is why they really matter. The Federal Reserve isn't a bank that has individual customers, so the rates the Federal Reserve charges or pays don't have a direct impact on any one person. However, because many financial institutions deal directly with the Federal Reserve on an ongoing basis, changes at the Fed do rapidly work their way across the spectrum of banks, lending institutions, and investment companies, and then they eventually reach your bills and account statements.
What rates does the Federal Reserve set?
The Fed has direct control over two interest rates. The better known of the two, the federal funds rate, is what financial institutions use for lending or borrowing money on an overnight basis. Because different institutions have different levels of liquidity, some may need to borrow money on an overnight basis to cover short-term needs, while others may have a temporary surplus of money that they can lend to other institutions. For example, if a commercial bank has recently made a large loan to a customer, it may not have sufficient deposits for its assets and liabilities to match. In this case, the commercial bank might choose to borrow money from another institution and pay the federal funds rate as interest. The lending bank might be in the reverse situation; it may have received a large deposit from a customer but failed to find another customer wanting a loan, so it might prefer to lend the money on an overnight basis in hopes that it will find a borrower soon.
The Fed also sets a second rate, called the discount rate, which is what the Fed itself charges for loans made directly to eligible financial institutions. This rate currently stands at 6.25% and is typically higher than the federal rate -- right now, it's 1% higher. The existence of the Fed's own lending operations, sometimes called the discount window, ensures that if more financial institutions want to borrow more money than to lend money overnight, the Fed will make liquidity available to avoid disruptions to the financial system.
But that's not my rate!
Although banks don't typically refer to either the federal funds rate or the discount rate in their transactions with customers, they do tend to make changes to their own benchmark lending rates, including the prime rate, in lockstep with the Fed's own rate changes. Within a day of any change in the federal funds rate, you can generally see announcements from major commercial banks, such as Wachovia (NYSE:WB), Wells Fargo (NYSE:WFC), and Bank of America (NYSE:BAC), announcing a corresponding change in their prime lending rates to customers.
In the past, the prime rate was used mostly for commercial loans to other businesses. However, with the rapid increase in the number of new products related to consumer loans, more and more loans have their interest rates tied to the prime rate. For instance, rates on home equity lines of credit, adjustable rate mortgages, and outstanding credit card balances are often calculated with reference to the prime rate. As a result, when the prime rate rises, so does the interest rate you pay on your house loan or credit card bill.
In addition, changes in the federal funds rate often lead to similar changes in rates paid on deposits, such as savings accounts and certificates of deposit. The changes don't necessarily flow through to savings rates as quickly as on loan rates, in part because the longer a bank can avoid raising the interest it pays to savers, the longer it enjoys a wider interest margin between what it earns on loans and what it pays on deposits. In other words, if the bank increases its prime rate and collects more interest from borrowers, while it keeps the amount of interest it pays to savers stable, then the bank gets to keep the difference as profit. The problem is that because all banks are trying to maximize their interest margins, competition for deposits causes financial institutions to raise their interest rates on savings in an attempt to attract money.
It's not just you
Just as banks pass on Fed rate increases by raising the prime rate, businesses that pay higher interest costs to banks for loans may have to raise prices to customers or else face lower profits. The resulting higher prices reduce demand for goods and services, thereby slowing the economy as a whole. And as interest rates rise, businesses considering new investments become more cautious, since borrowing money becomes more expensive and the return on surplus cash rises even without taking on any investment risk. These effects combine to give the Fed a degree of control over the entire economy simply by manipulating these short-term interest rates.
Fed rates even have effects worldwide. When interest rates in the U.S. are high, foreign investors have a greater incentive to hold U.S. dollars on a short-term basis. Conversely, if rates in the U.S. are lower than rates elsewhere, then capital may flow from U.S. dollars into the foreign currency of the country with higher rates. As interest rates change across the globe, currency markets continually struggle to achieve an equilibrium.
It may at first seem silly that the Federal Reserve's announcements carry so much weight in the financial community. Because of the wide-ranging impact the Fed's rates have, however, it's important for you to keep track of what's happening with interest rates and to know how they affect your personal finances.
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Fool contributor Dan Caplinger does not own shares in any companies mentioned in this article. Bank of America is a Motley Fool Income Investor selection. The Fool has a disclosure policy.
