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What Does It Mean When the Federal Reserve Changes Interest Rates?

International trade disputes, changes to the domestic and international economic outlook, and memories of the 2008 financial crisis can make even the most savvy financial consumer apprehensive.

Whenever the Federal Reserve announces that it’s raising or lowering the federal funds interest rate, economists, financial analysts, and consumers alike wonder where the economy is headed next. 

We talked to Greg McBride, chief financial analyst at Bankrate.com, about what it means when the Federal Reserve changes the interest rate, how it affects your bottom line.

What Raising or Lowering Interest Rates Mean?

The Federal Reserve (the Fed) is the United State’s central bank. And when they change interest rates they are essentially changing the cost of borrowing from the US Treasury. 

When Fed officials raise or lower the federal funds rate by even a fraction of a percentage point, this monetary policy shift affects the borrowing costs for banks and may affect the return earned on savings and any fixed income investments.

Where do we stand in fall 2019 with interest rates? 

The Federal Reserve raised interest rates nine times between 2015 and 2018 and as of November 2019, the Fed cut interest rates for a third time in only a few months. 

The way the Federal Reserve has positioned these recent fed funds rate cuts is to attempt to head off any potential problems in the economy before they materialize. It’s effectively taking out insurance to protect the ongoing economic expansion. 

Does that mean the Federal Reserve is worried about the US economy?

The concern is that uncertainty from things like trade disputes, slower economic growth overseas and very low inflation could drag the pace of US economic growth even lower. 

The way the dominoes fall is that when there’s uncertainty, businesses and consumers tend to clutch the pocketbook a little tighter. They don’t borrow, they don’t spend. In the case of businesses, they may be more cautious when it comes to investing and hiring. That’s what the Federal Reserve is trying to head off by reducing interest rates. Just giving a little bit of oomph to the economy.

How Does the Change in Interest Rate Affect Consumers?

Falling interest rates often reduce the cost of borrowing and also creates opportunities to reduce the cost of existing debt. While interest rate cuts reduce the cost of borrowing, they may also reduce the incentive earned on savings.

It’s a good opportunity to consider refinancing debts at lower interest rates, particularly if that debt was taken out a year or so ago when interest rates were higher, or if your credit score and creditworthiness have improved such that you can now qualify for a better rate than when you initially borrowed. 

The idea behind lower rates is to incentivize borrowing and spending and disincentivize saving. That’s how interest rates are used to bolster the economy.

What are the pitfalls of rushing out to take advantage of lower interest rates?

With the exception of the mortgage rates which have come down very dramatically, most other interest rates have come down only very modestly. And they’re still higher than they were a few years ago. 

So it’s not a massive windfall. The temptation is that in the name of lower interest rates, you might get lured into borrowing when you don’t need to, or borrowing more than you need to.

In terms of good personal finance housekeeping, regardless of the interest rate environment, you want to be regularly padding your emergency savings account, saving for retirement, and paying down debt.

And each of those steps also happens to be a very effective way of insulating yourself financially in the event of an economic downturn. If the economy does rollover at some point, you are better off if you have more savings and less debt. 

What Advice Would You Give to Young Professionals?

Individuals should consider their own financial profile, but consider taking advantage of opportunities to reduce their cost of debt. If you are able to refinance at lower interest rates, particularly on something like a mortgage or student loan, that can have a significant impact on your monthly budget. 

Also, consider shopping around and making sure you are getting the most competitive return on your savings account. But regardless of interest rates, make sure you’re working toward having an adequate emergency cushion. You may want to eventually have enough to cover six months of expenses. That’s a moving target and so that’s why you should be adding to that account every month. 

With regard to retirement savings, you may want to consider investing early, often, and aggressively. By saving in your 20s you may be able to harness the power of compounding the returns that come with the stock market. 

Disclaimer: The opinions expressed by the interview subjects are not necessarily those of Earnest.

Disclaimer: This blog post provides personal finance educational information, and it is not intended to provide legal, financial, or tax advice.