Buzz
After pushing interest rates up in recent years, the Federal Reserve reduced the federal funds rate last week for the first time since 2008. This decision has sparked a lot of buzz among financial experts – but what does this mean for you?
You're certainly not alone in wondering about this. The Federal Open Market Committee (FOMC), which sets monetary policy for the Federal Reserve System, meets eight times annually to assess and adjust the federal funds rate. That's why it often feels like the Fed is constantly discussing interest rates.
The federal funds rate plays a key role in determining Libor, the rate at which banks lend to each other for short-term loans that help maintain liquidity for day-to-day transactions and loan requests. When banks borrow from the Federal Reserve, they are charged a discount rate, which is always slightly higher than the federal funds rate to encourage borrowing among banks instead of directly from the Fed.
How the Federal Funds Rate Affects Short-Term Interest Rates
The federal funds rate isn't mandatory for banks, but according to Investopedia, the Federal Reserve system can adjust the money supply to bring interest rates closer to the target set by the federal funds rate.
The federal funds rate impacts us because it influences the prime rate, which is the interest rate that lenders charge their best clients. The prime rate is usually higher than the federal funds rate. When the FOMC changes the federal funds rate, it affects short-term variable interest rates, but you might not see your loan or credit card interest rates change immediately. It could take up to a year and a half for the effects of a federal funds rate change to work through the economy, as The Balance highlights.
As a regular consumer, you can think of the changes in the federal funds rate as having the opposite effect. If the rate drops, it stimulates the economy by encouraging borrowing, which is why the stock market often performs well after a rate cut. When the rate increases, banks usually tighten their lending standards. While you can still apply for a car loan or credit card, you're likely to face a slightly higher interest rate, even with good credit.
Both the federal funds rate and treasury bonds influence mortgage rates
If the federal funds rate affects short-term interest rates, what about long-term rates, such as those for a fixed-rate mortgage? Future homeowners often monitor the federal funds rate because it can influence fixed mortgage rates. However, a change in the federal funds rate doesn’t always guarantee a direct link to fixed-rate mortgage changes.
Mortgage rates are influenced by the bond market, particularly the mortgage bond market. Much like how you manage your personal investment portfolio, the Federal Reserve has its own, composed of roughly 60% U.S. Treasury securities and 40% mortgage-backed securities, as LendingTree explains. This is why many assume that only the 10-year Treasury note yield dictates mortgage rates, but it’s just one piece of the Fed’s portfolio. If mortgage-backed securities increase in value, mortgage rates tend to decrease; if they drop, mortgage rates typically rise.
Colin Robertson at The Truth About Mortgage states, “As a general rule, negative economic news tends to lower mortgage rates, while positive economic news pushes rates higher.” It’s more common to see small adjustments in rates rather than drastic changes, like those seen during a recession. However, even a slight increase or decrease in the interest rate can have a significant impact on your long-term housing costs.
This is why people often consider mortgage rates when the Federal Reserve changes the federal funds rate. However, these rate changes are part of a complex trickle-down process, not simply the Fed directly influencing mortgage lenders’ decisions.
