The Fed's Interest Rate: What It Means For You
Updated: Nov 3, 2019
This week The Federal Reserve lowered its benchmark interest rate for the third time this year. Does this matter to you? In this post, we will discuss what this means and what you may want to consider for your financial plan
What interest rate are we talking about?
The Federal Reserve Discount Rate is the interest rate that the United States’ central bank charges its member banks for borrowing money. Think of it this way: Your commercial bank has a specified requirement of how much money they have to keep in reserves. While your bank is doing business day to day, they may have shifts in their cash flow that leave them with a temporary shortfall in reserves. When this happens, they have to raise money to meet their reserve requirement. There are three main ways that they can do this.
They can sell investments from their portfolio to raise cash. This results in lost interest from getting rid of assets that are earning money.
They can borrow overnight money from other banks in the Federal Funds Market. This results in paying interest for borrowing money. (Many of us get some benefit from this market through our Money Market Funds!)
They can borrow from the Federal Reserve. The Discount Rate is the interest rate that banks have to pay for borrowing money.
This is good to know, because the Fed’s Discount Rate is used as an indicator of the direction other interest rates will go. Typically, if the rate your bank has to pay is higher, they will pass on higher interest rates to their customers and vice versa. The Federal Reserve Open Market Committee typically has eight scheduled meetings per year where they announce their interest rate policy.
Interest rates and the economy
It is helpful to think of our economy in a cycle. Each cycle is different, but we identify 4 phases of the cycle: Early Cycle, Mid Cycle, Late Cycle and Recession. Simply stated, our economy grows through early, mid, and late and then contracts during a recession. Right now, we are considered in the late cycle. Characteristics of a late cycle include peak economic activity, the rate of growth is still positive but slowing down, companies have reducing profit margins because of low unemployment, higher wages, and higher prices (inflation).
When the Fed raises rates, this is considered a tightening policy and when they lower rates, this is considered easing. With the announcement this week, we are seeing a policy of easing. The intention is that lower interest rates will extend our cycle of growth and prevent us from going into a recession. This is because with lower interest rates, costs are reduced to both companies and consumers which hopefully results in increased spending for both.
The Fed observed this week that the labor market remains strong and economic activity continues to rise at a “moderate” rate. They also noted that household spending is strong. However, they see weakness in business investments and exports. This could be an indication that corporations are being cautious in how they spend money with possibly a negative outlook on how trade wars and economic or political policy may affect their bottom line.
There is one key item to note right now that is a bit different from what we would expect from our economy at this stage. While we have low unemployment, we are not seeing a rise in inflation like we would expect. Technology and competition have changed industries and kept costs and prices low. This can be seen when you think about the effect Amazon has had on retail or streaming services have had on entertainment. The result is that industries that are normally cyclical and would under-perform at this stage are showing strength. Overall, we are still seeing strong earnings and growth in the stock market this year.
Good for borrowing
With The Fed lowering their rate, we typically see consumer rates follow the downward trend. This puts us in an environment that is good for borrowing money. It is typically not a good idea to take on debt just because interest rates are low, however if you are already carrying debt, now may be a good time to re-finance or consolidate.
Good reasons to restructure your debt:
You have taken our multiple loans on your home with varying interest rates
You are carrying a revolving credit card balance
You financed a purchase at a time when you had a lower credit score that resulted in higher rates.
Keep in mind that there are typically transaction costs when you restructure your debt, so take your time with this decision. It is not just about the interest rate. It is important to analyze your total payoff amount in both scenarios and how you will use the opportunity of reducing your payment to enhance your financial goals.
Not as good for savings
Low interest rate environments are not as good for savers. It is difficult to earn a decent yield on your money that you would like to keep safe. When interest rates on savings accounts are below inflation, then we are effectively losing money each year just by holding our money in cash. In the current environment, it may be wise to keep excess cash in a high yield savings account typically offered through online banks or a money market account.
Beyond cash, it is important to consider the risk vs. return relationship. Short-term, high quality fixed income investments are safer and will return a lower yield. While dividend paying stocks or lower quality bonds may pass on a higher return right now but come with exposure to losing principle. If the Fed’s policy of lowering rates is successful and our economic growth continues, then there is still money to be made by investing in quality companies. The chart below shows that historically the market has done well when global central banks cut their rates:
Remember to always consider your personal goals and ability to take on risk before investing.