Since the year 1913, a central bank known as the Federal Reserve has called the shots with economic policy. These policies have influenced markets here in the U.S. and worldwide over the years. With all the government institutions out there in 2018, you’re probably wondering: why should I care about the Federal Reserve?
The “Fed”, as we will call them, has a MUCH bigger influence on how you save and create wealth over time than you may know. As we continue to build out our knowledge of the markets and how to spend/save/grow money over time, a bit of insight into the Fed becomes critical.
You’re simply shooting yourself in the foot if you don’t understand the Fed or why it’s important.
Similar to Social Security, the Fed isn’t going anywhere soon. Let’s take a look at WHY exactly this private financial system has such a big effect on the global economy. With this background knowledge, you’ll set yourself up to be smarter with money and invest more wisely!
The Ultimate Financial Lever
Of all the methods of regulating the global economy, controlling interest rates is probably the most powerful. The Fed has the ability to do exactly this. The common term you’ll hear for the raising and lowering of interest rates is the Federal Funds Rate. Think of it as the godfather of all “interest rates” you may hear about in day to day life.
The Fed Funds Rate (FFR) is determined by the powers that be in the Federal Reserve. There are twelve members of the Fed who meet eight times per year. This group is known as the FOMC, or Federal Open Market Committee.
The FFR seems complex, but it comes down to this: Raising the rate makes it harder for banks to acquire and lend money. Lowering the rate makes it easier.
The reason the Fed raises and lowers the FFR is to control the supply of money available in the economy. The fed bases their decision on a number of economic indicators, pointing towards either a recession or inflation.
Looking at the pretty graph I’ve included to the right here, we get an idea of the historical FFR. It peaked around 20% in the 80’s and has dropped steadily since then. When the economy crashed in 2007, the Fed brought the rate down towards 0%.
Now that we’ve covered some of the basic Fed jargon, let’s explore why it would ever matter to you.
Effect on You and Me
The stated goal of the Fed is to “promote sustainable growth, high levels of employment, and stability of prices to help preserve the purchasing power of the dollar”. Their desire to keep the economy healthy all comes back to interest rates.
Eight times per year, you will find everyone on Wall Street glued to their TV’s at the same time. These meetings are huge, as they influence the course of the stock markets, bond markets, and much more. Most importantly, the average citizen is directly affected by these meetings.
For this example, let’s assume that the Federal Reserve decides to RAISE interest rates at their next FOMC meeting. What kind of fallout would we be facing as an individual?
A hike in interest rates means that any mortgage that isn’t fixed (like an ARM) will rise. The benefit of a fixed rate mortgage is the Fed rate hikes won’t take a chunk out of your paycheck. If it’s not fixed, be ready to shell out more cash.
Because it’s now more expensive for banks to borrow money, they will make it more difficult for consumers to spend with credit cards. The APR rate you pay might rise on the card, and banks will also be stricter with giving out cards in the first place. Short-term borrowing is more difficult as well.
The majority of us have fixed rate student loans from federal institutions. This means rates you pay today would be unchanged if the Fed raises rates. If you are a year away from going to college, you’ll be paying a higher rate when it comes time to get a loan!
Also, many private student loans work off a variable rate. This means that monthly payment will likely be going up.
Running a Small Business
Small businesses thrive off a healthy cash flow. A rise in rates means cash is now harder to come by, which negatively impacts your small business in the short run.
Most small companies rely on loans, which are now more expensive to get. Higher interest rates tend to signal a healthier overall economy, so the effect is positive in the long-term.
The stock market is not directly tied to the changing of Fed interest rates in any way. However, Wall Street uses the FOMC meetings as a gauge of how the economy will look in the short-term future. A rise in interest rates usually sends the stock market plunging for a day.
This means your favorite stocks might take a hit. Investors associate higher rates as bad, even though the economy could be doing better in the long-term. Watch out for massive swings on those eight days per year that the FOMC meets.
A rise in interest rates makes the average person less likely to spend freely. A rise in credit card rates, as well as a rise in prices companies eventually charge for their products, deters spending from rising. You might have to think twice about getting that second pair of Nike’s.
The Bottom Line
The Federal Reserve has control over the broader economy and influences us in many small ways as seen above. We covered an example where interest rates go up; in the opposite scenario, assume the opposite effect on mortgages, credit cards, etc. Back in 2008 when the economy was reeling, rates continued to drop to make it easier on the average citizen and businesses of all sizes.
Getting your head around the importance of the Fed is another step in the right direction towards understanding the markets and making your money work for you. Until next time!
All opinions expressed on this blog are solely those of Home at 30 and are in no way affiliated with any other organization or institution. The purpose of this blog is to give general education and information about investing, wealth, careers, and college; It is not intended to be professional advice.
Author: Joe Savoia
Joe is a 2014 graduate of Northeastern University and currently works in a field sales role for technology company Acquia. He has worked internationally as one of Acquia’s earliest Australia-based employees and helped in the early stages to develop that region. Today Joe is based out of Boston and lives in Somerville, MA. Joe’s primary interests vary widely, including everything from robotics/AI to finance, blockchain, and the rapidly evolving world of tech we live in.