How Does the Fed Affect Your Money?

Are you planning to apply for a mortgage, borrow money for a big-ticket purchase or build an investment portfolio for future goals? If so, it’s important to understand how Federal Reserve (Fed) interest rate decisions could affect your decision.

The Fed meets eight times a year to set monetary policy, including adjusting the target short-term lending rate, known as the federal funds rate (fed funds rate) — the interest rate banks charge each other for overnight loans. But its influence doesn’t stop there.

The fed funds rate sets the course for various consumer borrowing and savings rates. It can also affect performance trends in the stock and bond markets. Accordingly, the Fed’s monetary policy decisions typically have considerable reach.

The Fed Can Influence Your Borrowing Costs

When the Fed raises or lowers interest rates, the effects typically filter through to consumer loans.

Auto Loan Interest Rates

Rising interest rates mean financing a car will become more expensive. Conversely, falling interest rates typically lower the cost of financing a vehicle.

Student Loan Interest Rates

If you have a privately financed variable-rate student loan, a Fed rate change will likely cause your interest rate to increase or decrease. However, if you have a federal fixed-rate student loan, a Fed rate change won’t alter the interest rate on your debt.

Mortgage Rates

While the fed funds rate doesn’t directly influence longer-term mortgage rates, there’s a connection. That’s because the Fed’s monetary policy sets the general course for interest rates. So, when the Fed adjusts its short-term rate target, other interest rates typically move in the same direction.

Furthermore, it’s important to note that mortgage rates may move despite Fed action because fixed-rate mortgages more closely track the 10-year Treasury note yield.¹ In addition to the fed funds rate, inflation and investor expectations for economic growth often influence the 10-year Treasury yield.

Credit Card Interest Rates

When the Fed raises rates, the cost of credit increases, making it essential to factor in the additional expense of carrying debt into your budget. This is especially true of variable-rate credit card debt, where you’ll see an immediate spike in interest rates.

Fed Policy Helps Determine the Interest on Your Savings

The fed funds rate also drives interest rates you earn on popular savings vehicles.

Bank Savings Accounts

Banks typically peg the interest rate they pay to their savings account owners to the prevailing fed funds rate.

Certificates of Deposit (CDs)

The Fed’s monetary policy is one factor that CD issuers consider when setting the interest rate they pay CD buyers. Banks typically offer higher interest payments when the Fed raises interest rates to attract depositors. When the Fed cuts rates, CD rates tend to fall.

CDs usually pay higher rates than savings accounts because they require depositors to keep their money in the CDs for specific periods. Longer-term CDs generally pay higher interest rates than shorter-term CDs. However, when rates are rising, having funds sitting in a longer-term CD means you won’t be able to immediately reinvest the funds at a higher rate.

Cash Equivalents

Yields on Treasury bills, high-quality commercial paper and other highly liquid, ultra-short-term assets generally track the fed funds rate. Yields on these cash equivalents may vary slightly depending on the issuer and the maturity. For example, non-government issuers and longer-term securities typically offer higher yields than government-backed and shorter-maturity instruments.

The Fed’s Funds Rate Affects Stock Performance

The Fed’s interest rate policy can influence stock performance through borrowing costs, consumer spending and investor behavior.

Corporate Profits

Higher interest rates increase companies' borrowing costs, which can reduce corporate profits and pressure stock prices. For example, a manufacturing company might face higher costs for financing new equipment, potentially reducing its profitability and stock value.

Conversely, lower interest rates reduce companies’ borrowing costs. This can translate to higher profits and, ultimately, higher stock prices. For instance, a tech company might take advantage of lower interest rates to refinance research and development projects. Lower interest costs reduce overall expenses, enhancing the company’s growth prospects and stock performance potential.

Consumer Spending

Higher interest rates can discourage consumer spending by making credit more expensive. When consumers cut back their spending, company revenues slow, which can weigh on a company’s stock price.

Conversely, lower rates reduce borrowing costs, often persuading consumers to spend more. Increased consumer spending can boost corporate revenues, particularly in the retail and consumer discretionary sectors. For example, lower rates make it easier and more appealing for consumers to finance big-ticket items like cars, appliances and travel.

Discount Rate and Stock Valuation

The fed funds rate affects the discount rate used to value companies' future cash flows. Higher rates increase the discount rate, reducing the present value of future earnings and potentially lowering stock prices. Lower rates decrease the discount rate, increasing the present value of future earnings and potentially raising stock prices.

Fed Policy Has a Close Relationship with Your Bond Portfolio

Bond prices typically have an inverse relationship to interest rates, so changes in the fed fund rate can affect the overall value of your bond portfolio.

Existing Bonds

When interest rates rise, older bonds with lower yields become less desirable, causing their prices to drop. This price decline is more pronounced among long-term bonds, as they are more sensitive to rate changes. Meanwhile, when interest rates fall, existing bonds with higher yields gain value because investors are willing to pay a premium for that yield advantage.

Newly Issued Bonds

When the Fed raises interest rates, newly issued bonds offer higher rates than existing bonds to remain competitive. This makes them more attractive than older bonds with lower yields. Conversely, when the Fed lowers interest rates, newly issued bonds provide lower yields, making them less appealing than existing higher-yielding bonds.

Corporate and High-Yield Bonds

Investment-grade and high-yield corporate bonds tend to offer higher yields than government bonds. Their yields tend to be less sensitive to the fed funds rate and more aligned with the broad economy and the issuer’s financial condition. Credit quality and default risk are typically the key metrics that corporate bond investors consider.

Are You Ready for What’s Ahead?

Navigating interest rate uncertainty can be challenging, but there are strategies to help manage the impact on your investments. As distinctive asset classes react differently to interest rate changes, an actively managed, well-diversified portfolio can help manage risk and potentially enhance long-term returns.

We’re here to help you prepare your portfolio for all economic conditions.