The Federal Reserve and Interest Rates in Your Life

We regularly hear news reports about a decision by the Federal Reserve (the Fed) to raise or lower interest rates or to leave them unchanged. Recently, Federal Reserve Chairman Ben Bernanke announced that the Fed would hold the line on interest rates it controls until the middle of 2013. The announcement of the Fed’s interest rate policy over an extended period of time was unprecedented. So does that mean the rates that have the most impact in your life will remain unchanged over the same period?

The simple answer is no. The Federal Reserve’s interest rate policy can impact the rates paid on your interest-bearing accounts, bonds you may own or the rate you will pay on your auto loan. But the impact may be indirect as other factors can also affect how the market sets interest rates on other instruments.

Comparing short and long-term interest rates

The Fed controls monetary policy, influencing the availability and cost of money and credit to help manage the direction of the economy. While the Fed has a number of tools at its disposal, one of its most powerful is control of the Federal Funds (or “Fed Funds”) interest rate. This is the rate that banks charge each other for overnight loans of money from reserves that are held by the Fed. The free market actually sets the rate, but the Fed establishes a target for it.

If the Fed is trying to boost economic growth, particularly during a recession or period of slow growth, it will lower the Fed Funds rate. If the economy appears to be growing too fast – meaning that there is an increased threat of a serious inflation problem – the Fed will usually raise the Fed Funds rate target to try to moderate that growth. We’ve seen both types of actions happen on multiple occasions.

For example in the early 1980s, the Fed raised short-term interest rates sharply in a move to help thwart what was a period of rampant inflation in the U.S. This move is credited by many with helping to break the inflation problem and set the economy on a path of steady growth tied to modest inflation.

The challenge today has been quite different. The financial crisis that exploded in the fall of 2008 steepened the recession. Since December 2008, the targeted Fed Funds rate has been 0 to 0.25 percent, as low as it can be set. While the economy eventually regained some momentum, the rate of recovery has been so slow that the Fed has not adjusted its target rate since that time, and now apparently won’t before the middle of 2013.

What the Fed Can’t Control

While the Fed’s stance on short-term interest rates influences other interest rates, such as those on bonds or home mortgages, other factors can come into play as well.

For example, longer-term interest rates are often closely tied to fluctuations in the cost of living. If the inflation rate should suddenly jump, chances are that interest rates on government and corporate bonds and on personal borrowing instruments (mortgages and car loans) would rise as well. History shows that interest rates tend to track on a path similar to the inflation rate.

In fact, a sudden bout of inflation would likely cause the Fed to change its own interest rate stance sooner than 2013, which could contribute to a sudden upturn in longer-term interest rates.

Another potential concern is that investors in U.S. government bonds, which are issued to deal with the nation’s debt, may start shifting money away from that asset class. If the demand for bonds issued by the government declines, the yield on those securities could move higher. That was already happening in 2010, as the economy showed promising growth. But yields on longer-term government debt securities have declined again lately due to signs of slower economic growth and fears about the risks of another recession.

A key point to keep in mind is that even though the Federal Reserve may be committed to maintaining a low Fed Funds rate for the next two years, it doesn’t mean that rates on other types of instruments might not change between now and then. If you are considering buying or refinancing a home or locking in a CD rate for an extended period of time, remember that interest rates on most types of debt are subject to fluctuation independent of Federal Reserve policy.