The Federal Open Market Committee (FOMC) of the Federal Reserve meets regularly to decide what, if anything, to do with short-term interest rates. Stock traders almost always rejoice when the Fed cuts interest rates, but does a rate cut equal good news for everyone? Read on to find out.
What Is the Rate?
When the Fed "cuts rates," this refers to a decision by the FOMC to reduce the federal funds target rate. The target rate is a guideline for the actual rate that banks charge each other on overnight reserve loans. Rates on interbank loans are negotiated by the individual banks and usually stay close to the target rate. The target rate may also be referred to as the "federal funds rate" or the "nominal rate."
The federal funds rate is important because many other rates, domestic and international, are linked directly to it or move closely with it. (For more on this, read "The Federal Reserve: Monetary Policy.")
Why Does It Change?
The federal funds rate is a monetary policy tool used to achieve the Fed's goals of price stability (low inflation) and sustainable economic growth. Changing the federal funds rate influences the money supply, beginning with banks and eventually trickling down to consumers. (For further reading on the impact of money supply on the economy, see "The Federal Reserve's Fight Against Recession.")
The Fed lowers interest rates in order to stimulate economic growth. Lower financing costs can encourage borrowing and investing. However, when rates are too low, they can spur excessive growth and perhaps inflation. Inflation eats away at purchasing power and could undermine the sustainability of the desired economic expansion.
On the other hand, when there is too much growth the Fed raises interest rates. Rate increases are used to slow inflation and return growth to more sustainable levels. Rates cannot get too high, because more expensive financing could lead the economy into a period of slow growth or even contraction. (For more, read "How Much Influence Does the Fed Have?")
How Interest Rate Cuts Affect Consumers
The Fed's target rate is the basis for bank-to-bank lending. The rate banks charge their most creditworthy corporate customers is known as the prime lending rate. Often referred to as "the prime," this rate is linked directly to the Federal Reserve's target rate. Prime is pegged at 300 basis points (3%) above the target rate.
A rate cut could help consumers save money by reducing interest payments on certain types of financing that are linked to prime or other rates, which tend to move in tandem with the Fed's target rate.
A rate cut can prove beneficial with home financing, but the impact depends on what type of mortgage the consumer has, whether fixed or adjustable, and which rate the mortgage is linked to. (To compare the advantages and disadvantages of these two types of mortgages, read "Mortgages: Fixed-Rate Versus Adjustable-Rate.")
For fixed-rate mortgages, a rate cut will have no impact on the amount of the monthly payment. Low rates can be good for potential homeowners, but fixed-rate mortgages do not move directly with the Fed's rate changes. A Fed rate cut changes the short-term lending rate, but most fixed-rate mortgages are based on long-term rates, which do not fluctuate as much as short-term rates.
Generally speaking, when the Fed issues a rate cut, adjustable-rate mortgage (ARM) payments will decrease. The amount by which a mortgage payment changes will depend on the rate the mortgage uses when it resets. Many ARMs are linked to short-term Treasury yields, which tend to move with the Fed or the London Interbank Offered Rate (LIBOR), which does not always move with the Fed. Many home-equity loans and home-equity lines of credit (HELOCs) are also linked to prime or LIBOR. (For more on this, read "Home-Equity Loans: The Costs" and "ARMed and Dangerous.")
The impact of a rate cut on credit card debt also depends on whether the credit card carries a fixed or variable rate. For consumers with fixed-rate credit cards, a rate cut usually results in no change. Many credit cards with variable rates are linked to the prime rate, so a federal funds rate cut will typically lead to lower interest charges. (For more on credit card interest, see "Understanding Credit Card Interest.")
It is important to remember that even if a credit card carries a fixed rate, credit card companies can change interest rates whenever they want to, as long as they provide advanced notice (check your terms for the required notice).
When the Fed cuts interest rates, consumers usually earn less interest on their savings. Banks will typically lower rates paid on cash held in bank certificates of deposits (CD), money market accounts and regular savings accounts. The rate cut usually takes a few weeks to be reflected in bank rates.
CDs and Money Market Accounts
If you have already purchased a bank certificate of deposit (CD), there is no need to worry about a rate cut because your rate is locked in. But if you plan to purchase additional CDs, a rate cut will result in new, lower rates. (To learn about CDs, read "Step up Your Income with a CD Ladder.")
Deposits placed into money market accounts (MMA) will see similar activity. Banks use MMA deposits to invest in traditionally safe assets like CDs and Treasury bills, so a Fed rate cut will result in lower rates for money market account holders. (For more on Treasury bills, read "Money Market: Treasury Bills.")
Money Market Funds
Unlike a money market account, a money market fund (MMF) is an investment account. While both pay higher rates than regular savings accounts, they may not have the same response to a rate cut. (For more on MMFs, read "Do Money Market Funds Pay?")
The response of money market mutual fund (MMMF) rates to a rate cut by the Fed depends on whether the fund is taxable or tax-free (like one that invests in municipal bonds). Taxable funds usually adjust in line with the Fed, so in the event of a rate cut consumers can expect to see lower rates offered by these securities.
Because of their tax-exempt status, rates on municipal money market funds already fall beneath their taxable counterparts and may not necessarily follow the Fed. These funds also may be linked to different rates, such as LIBOR or the Security Industry and Financial Markets Association (SIFMA) Municipal Swap Index.
The Bottom Line
The Federal Reserve uses its target rate as a monetary policy tool, and the impact of a change to the target rate depends on whether you are a borrower or a saver. Read the terms of your financing and savings arrangements to determine which rates are relevant to you so that the next time the Fed cuts interest rates, you will know exactly what the cut means to your wallet.