In the stock market update 2 weeks ago, we mentioned that the Fed, the U.S. Federal Reserve, would make a decision on interest rates. Interest rates increased by 0.25 percent point. But um, what the F does this actually mean? What does an interest rate increase mean globally and what does it mean in your wallet? Sit back, take a moment, and read along!
What does an interest rate increase mean
When people talk about interest rate increases, they often talk about short-term interest rates.
By law, banks that accept deposits from people (savings) are required to keep a certain amount on hand so people can withdraw money. That amount is called their “reserve requirement” and is based on a percentage of the total amount of money people have deposited with that bank.
But the amount of money a bank holds changes as people deposit or withdraw money. Logical. At the end of the day, if a bank thinks it has more cash on hand than it needs to meet its reserve requirement, it can lend some of the extra money to another bank that thinks it is short of cash. The interest rate that banks charge each other for these loans is called the federal funds rate. In this article, we talk about “interest.
Fed sets “target rate”
Eight times a year, the Federal Open Market Committee (FOMC) – a group of people at the Fed charged with setting monetary policy – meets to decide what the ideal interest rate should be, based on how healthy the economy is. They may also change outside their regular schedule of eight meetings, for example, if the economy is erratic.
The FOMC cannot simply dictate how much banks can charge each other; that is done through negotiations between the two banks in question. Instead, the FOMC sets a target federal funds rate within a certain range. In March 2020, they set the target interest rate at 0.25% to 0.50%.
The interest rate that banks end up charging each other is called the effective federal funds rate. To get it within the target range, the FOMC either adds money to the financial system, increasing supply and lowering the effective interest rate, or takes money out of the system, decreasing supply and raising the effective interest rate.
How does this interest rate affect the economy?
Interest affects how much banks pay to borrow and lend, and so it affects how much they pass on to you for other financial products, such as a mortgage. That makes it a tool for the Federal Reserve when it comes to influencing the health of the economy. One would like to have inflation running, and avoid stagnation.
Tip: the book “our money is broken” by Messrs. Slagter. Here they elaborate on these resources and how it doesn’t actually have the intended effect.
Lower interest rates boost economy
When interest rates fall, interest rates on savings products, such as savings accounts, typically fall as well. But it can also lower the interest rates you pay on debt products, such as auto loans, personal loans and credit cards.
This makes it less attractive to save money – after all, you receive little interest on your savings account – and more rewarding to borrow money. This encourages people to borrow more money and save less, we have seen this happen in recent years. So if the economy needs some help, the Fed can lower interest rates to stimulate economic activity (or how much people borrow and spend). That’s why the Fed cut interest rates to zero in March 2020 (and kept them low for so long). Since then, people have started investing and buying houses en masse.
Higher interest rates help curb inflation
It also works the other way: as interest rates rise, so do the interest rates you can earn on savings accounts, for example, but also the interest rates you have to pay on loans (such as a mortgage), for example.
This makes it more worthwhile to save money and less worthwhile to borrow money. So if the economy seems to be growing too fast, which can lead to inflation, the Fed can raise interest rates to slow economic activity.
What does this mean to you?
It looked like the Fed might raise interest rates to 0.50% this month. But then Russia invaded Ukraine, creating even more uncertainty in the global economy. Yet inflation has now reached its highest point in 40 years. So the Fed is still raising interest rates, but only to 0.25%.
This is the first time in three years that the Fed has raised interest rates (instead of lowering them or keeping them the same). Moreover, the Fed expects to raise interest rates six more times in 2022.
Getting more out of your savings
This means you may earn a little more on savings. The interest rate on many savings accounts is closely linked to the target interest rate because the interest rate is the amount the bank earns on your deposited money.
A target interest rate of 0.25% is still historically quite low, so banks may not yet increase their payouts. But there is still a chance that the interest rate on your savings will go up. How quickly this will happen is the question.
You also pay more interest on debts and loans
Higher interest rates make debt more expensive. The amount you pay for loans and mortgages is likely to rise…. In fact, many lenders have already raised rates in anticipation of this change. You can also see in the Netherlands that mortgage lenders have already raised their interest rates slightly.
Conclusion?
Interest rates are dropping: borrowing good, saving bad, just to put it very bluntly. Rising interest rates: saving good, borrowing somewhat less favorable. With current inflation, this rate hike could help cool things down. Let’s hope so, because prices are skyrocketing!
In the end, it all boils down to: make sure you have a good buffer, have insight into your behavior and spending patterns, set aside some money for later (retirement, investing) and after this article, don’t read too much disturbing news because you only have influence on 1 aspect: on your own money, backup and savings account.
