The Federal Reserve raised interest rates by 0.25%. (Photo by Chip Somodevilla)
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The Federal Reserve recently announced it was changing interest rates by a quarter of a percent, for the first time since 2018. It also suggested rates would rise at each of the remaining Federal Reserve meetings for the remainder. of 2022. To fully understand the situation and its impact on your investments and retirement accounts, you will need to understand the basics.
What are the interest rates?
When the Fed announces it is raising rates by 0.25%, it is referring to the federal funds rate, which is the target interest rate set by the Federal Open Market Committee, or FOMC. The FOMC is the policy-making section of the Federal Reserve System, and they set policy at meetings throughout the year.
Although the FOMC sets the target federal funds rate, it is only a suggestion and the actual interest rates are determined by commercial banks and lenders. The actual rate is set based on market supply and demand and short-term reserves held in commercial banks, which happens overnight in what is known as the overnight market. Banks take their excess reserves and keep a percentage of the excess to cover deposits, while lending the rest to other banks. If the market widens widely, the central bank can intervene to influence the rate.
So what is the impact of the Federal Fund rate?
The federal funds rate impacts almost everything as it affects monetary and financial conditions in the United States, ranging from inflation and growth to employment and the economy as a whole.
While the rate change won’t immediately change your mortgage rate or retirement account, it does have a ripple effect on the economy that will eventually affect you. As the base short-term interest rate has risen, so has everything else. New debts are getting more expensive, from mortgages and auto loans to credit cards and college loans. Any debt that is not at a fixed rate will increase because the prime rate is influenced by the federal funds rate.
The increase in the federal fund rate also makes it more expensive for businesses to borrow money for projects and expansions. Bond interest rates also increase, and often savings account interest rates increase when the federal funds rate increases.
These increases and the ripple effect impact the stock market, and investors and analysts typically watch the FOMC carefully for changes in the target rate.
What happens when the Federal Reserve raises interest rates? (Photo by Brooks Kraft)
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Why is the Fed changing rates now?
The recent inflation occurring after the impact of the pandemic is the likely reason for the current rate hike. The Fed has a mandate to keep inflation in the 2-3% range, or what it calls stable prices, as the goal of healthy and steady inflation that does not harm the economy. When inflation is above or below this range, they implement policies, either accommodative or restrictive, to bring inflation back into the target range. In general, the first tool they use to adjust inflation is to adjust interest rates. Pushing the rate down often stimulates the economy to fight a recession, while raising the rate is a tool they use to fight higher inflation rates. Our current inflation rate is above 7%, which is driving this rate hike. If the federal government raises rates, it restricts the flow of money, which discourages a price increase.
What is the impact of interest rates on retirement accounts?
When interest rates rise, they cause bond prices to fall. This can impact your investment or retirement accounts. Rising interest rates also have an impact on stock markets, but not in a directly opposite way. Rising rates can cause companies to change the way they do business, which eventually leads to changes in their stock and impacts the market. An increase in the federal funds rate increases interest rates on savings accounts and CDs, so if you have investments in these vehicles, you will see them increase. Mortgage rates are also rising, which may impact potential real estate investments.
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