Economists and financial experts pay close attention to interest rate fluctuations because of their ripple effect on global asset markets. It's common for investors to celebrate a Federal Reserve rate cut, but is this good news for everyone? Borrowers gain while lenders and savers lose as interest rates go down.
But what about regular households? Both consumer spending and economic growth are sensitive to interest rate fluctuations. This is because an increase in the interest rate also raises the cost of borrowing money and financing a credit transaction. Just what does this imply? If you want to know more, read on!
"Rate cuts" refer to a decision by the Federal Open Market Committee (FOMC) to lower the target rate for the federal funds rate. The real interest rate that commercial banks charge each other for overnight reserve loans is based in large part on this target rate. Banks negotiate interest rates on interbank loans, which are typically relatively stable relative to the target rate. Other names for the target rate include the federal funds rate and the nominal interest rate.
Because so many other domestic and international rates are linked to or closely follow the federal funds rate, it is of paramount importance.
Exactly why do interest rates fluctuate?
The federal funds rate is an instrument of monetary policy used by the Federal Reserve to encourage low inflation and robust economic growth. When the federal funds rate changes, it impacts the availability of cash, first in the banking system and later in people's wallets.
When the Fed wants to spur economic growth, it lowers interest rates. Economic growth is encouraged by the lowered cost of borrowing and investment. However, if rates are too low, it could lead to inflation and uncontrollable growth. The erosion of buying power caused by inflation threatens economic growth stimulation attempts.
When growth becomes unsustainable, however, the Federal Reserve will raise interest rates. Raising interest rates allows inflation to be controlled and growth to be restored to more sustainable levels. If interest rates were permitted to increase too high, the economy might enter a period of sluggish growth or even contraction.
On August 27, 2020, the Fed announced it would stop raising interest rates due to unemployment falling below a certain threshold, provided that inflation remained low. And it changed its inflation aim to an average rather than a hard and fast number so that times of inflation over its former target of 2% might compensate for periods below that number.
Sixthly, financing is determined by the Federal Reserve's target rate, which is used in interbank lending. Commercial banks commonly use the term "prime lending rate" when discussing the interest rate at which they lend to their best corporate customers. The prime lending rate is the most often used reference rate and is tied to the Federal Reserve's target rate. The prime rate is currently 3% over the target rate.
Depending on the buyer's assets, liabilities, income, and creditworthiness, the final price could be more than the prime rate. When the Federal Reserve lowers the target federal funds rate, other interest rates, such as prime, often fall in line with it, benefiting consumers by lowering their monthly payments.
Mortgages
If you have a fixed-rate mortgage and the interest rate drops, your monthly payment won't change. The current low-interest rate is great news for those looking to buy a home, but it's important to note that fixed-rate mortgages are relatively immune to fluctuations in the Federal Reserve's rates. On which most fixed-rate mortgages are based, long-term interest rates are less volatile than short-term interest rates, but a decline in Fed rates will affect the short-term loan rate.
It is common for ARM payments to decrease when the Federal Reserve lowers interest rates. Rates used by mortgages during reset might cause various possible changes in monthly payments. Short-term Treasury yields are commonly used as a benchmark for ARMs because they tend to fluctuate with Federal Reserve policy, unlike London.
Interbank Offered Rate (LIBOR) is sometimes used since it does not correlate with the Fed's actions. Home equity loans and home equity lines of credit are tied to the prime rate or the London Interbank Offered Rate (LIBOR).
Postal Money Orders
In addition to the type of rate your credit card carries, this is what will decide the extent to which a rate cut reduces your credit card debt. Customers whose credit card interest rates cannot be lowered will rarely profit from such a reduction. Because credit card interest rates are typically pegged to the prime rate, a decline in the federal funds rate usually results in reduced interest rates for consumers.
