The Fed’s Interest Rates and Other Imaginary Friends

Here is a fact about finances that feels like it can’t possibly be true:


Money doesn’t actually exist.


Yeah, I know. Sounds crazy. But even though money is a mundane (and often stress-inducing) part of our everyday lives that affects every single person in the world, money is actually nothing more than a huge and amorphous idea that we all share.


Money may be valuable, but that’s only because we have all agreed to treat it as valuable. It cannot be eaten, worn, used to build shelter, or even spent outside of the specific places that accept it as legal tender. We have a social agreement that money is valuable, and that’s all that keeps it from becoming worthless paper, metal, and numbers on a digital screen.


At no time is the imaginary nature of finance more clear than when we are in a financial crisis. With the stock market seeming to be in freefall without a parachute or a net, it suddenly becomes clear that the things that were universally valued just a few weeks ago relied on a social contract for their value.


We’ve seen this happen with the humble roll of toilet paper. Over a matter of days, TP went from a simple tool for keeping one’s nethers clean (not to mention a method for making a mess at your least favorite teacher’s house), to a hot commodity worthy of panic-buying, fisticuffs, hoarding, war-profiteering, and general insanity.

Into this world of imaginary money causing real freakouts strode Jerome Powell, chair of the Fed (The Federal Reserve if you’re nasty), who announced last weekend that interest rates will be slashed to “near 0.” This can leave regular folks (such as my friend Barb, who suggested I write about this topic) wondering what the heck is going on, and if this move will mean anything to anyone who doesn’t keep a vault full of money to swim in.


So here’s the scoop on what this move does and how it might affect normal people’s lives:


What Exactly Is the Fed?

The Fed is the sort of government entity that may sound like it belongs in a monopoly-themed dystopia, which isn’t helped by the fact that the Fed decides what money is worth (cue ominous music). Though that might sound a little worrisome, the Fed serves a good and important purpose in our economy.

The role of the Federal Reserve is to maintain economic stability. That means it’s their job to try to get ahead of financial trends that could cause runaway inflation or stagnant economic growth. In a nutshell, runaway inflation occurs when the price of goods rises too quickly, while stagnancy occurs when people are not spending money and even lowering the cost of goods doesn’t tempt folks to spend.


(We have seen both of these things happening in the microcosm of the first weeks of COVID-19 reaction, from that guy in Tennessee selling Purell for $70 a bottle before he ran afoul of price gouging rules, to the fact that airlines are offering flights for $18 to try to entice passengers to fly.)


So how does the Fed work to keep things stable and avoid such huge fluctuations? Among other strategies, the one you are most likely to be familiar with is their control of interest rates. The Fed sets the federal funds rate in order to get ahead of anticipated inflation or stagnancy.


Okay, So What’s the Federal Funds Rate?

So what do you imagine is happening to the money you currently have sitting in the bank? Most of us have a mental image of something like Gringotts Bank from Harry Potter. If you’re not Potter-fluent, Gringotts had a single huge branch in London, which stood atop a ginormous warren of underground vaults one reached via cart that ran at break-neck speed. Once you reached your vault, you could access the gold coins you kept there.


This is not how banks work in the real world.

Not only would keeping your entire deposit in a vault be a serious security hazard (see the successful theft from Gringotts in book 7), but you’d only be able to access your money from one specific branch. Not at all convenient.


No, the money you keep in the bank is being loaned out to others.


Banks are required by the Fed to keep a cash reserve that is equal to a percentage of their deposits. However, banks may experience day-to-day shortfalls depending how much and what kind of business they conducted on any given day. Banks that have a surplus above their required reserve may lend excess to banks facing a shortfall. These are overnight loans that are paid back the very next day, and keep every bank compliant with their reserve requirements.


And even though banks can trust each other that they are good for the amount loaned, they still charge each other an interest rate for these very short-term loans. However, they do not get to decide the rate all by themselves. Instead, they have to use the federal funds rate set by the Fed as a guideline for lending. As of March 15, 2020, the federal funds rate was set to between 0% and 0.25%.


Why Lower the Federal Funds Rate?

So far, so good. But what’s the point of Ol’ Jay-Powell slashing the federal funds rate?


Here’s what this does: it makes it cheaper for banks to borrow money from each other.


But wait: there’s more!


Banks pass that savings along to consumers.


A lower federal funds rate means banks will lower the interest rates they charge to consumers, particularly on short-term lending.

This is why you’ll see rates lowered when there are market downturns, recession concerns, or when a global pandemic keeps everyone housebound and not spending money. Making money cheaper for banks to borrow can cause a cascade effect, since the banks also make money cheaper to borrow in the hopes of enticing potential borrowers. These borrowers will take on mortgages, borrow for their small businesses, buy cars, and engage in other economy-stimulating purchasing.


Does This Mean I Can Get a 0% Mortgage? Sweet!

That’s a negatory, good buddy. The 0% to 0.25% federal funds rate is not what consumers are going to see. It’s simply the benchmark for bank-to-bank lending.


The lowest rate consumers can receive is what’s known as the prime rate. This is the rate that lenders offer to their most creditworthy borrowers, and it is generally set at about 3% above the federal funds rate. This means that if you have excellent credit, you can generally qualify for a loan set at the current prime rate, which is tied to the federal funds rate. When the federal funds rate goes up, so does the prime rate, and when it goes down, down comes prime.


In addition, federal funds rate cuts affect short-term lending, which means mortgage rates may or may not go down in response to this cut. Mortgage interest rates are more closely tied to the 10-year Treasury yield, rather than the federal funds rate. That’s because 30-year fixed mortgage rates need to be tied to a longer-term benchmark. While the same economic forces that prompted Jay-Pee to lower fed rates may have a longer-term effect on mortgage rates, it’s not necessarily something you’ll see in mortgage lending in the coming weeks.


Okay, So How’s This Rate Cut Going to Affect Me?

Here we get to the nitty-gritty. There are a couple of consumer-facing banking options that will change as a result of this cut. Specifically:


1. Savings and CD rates will likely be lowered. The entire point of cutting the fed rate is to try to encourage people to spend money. When this rate is lowered, banks will generally lower their APY on savings accounts, CDs, money market accounts, and other interest-bearing consumer products. This can be bad news for savers, but I would still strongly urge all of my readers to continue saving their money. Even if your APY is lackluster, having money set aside in case of an emergency (ahem) is always going to be a smart money move.


2. This could affect your credit card interest rate. Credit cards with variable interest rates base them on the prime rate (which is about 3% above the federal funds rate). Of course, you know there ain’t nobody getting single digit interest rates on a credit card. That’s because credit card issuers also add an additional margin to their prime rate. (Average credit card rates as of December 2019 were 17.36%). If you are carrying a balance on your credit card, you may find that you’re paying a little less in interest sometime in the next 60 to 90 days, since credit card issuers aren’t exactly snappy in the “let’s adjust rates down” race. However, if you do carry a balance, this may be a good time to look for another credit card with a lower interest rate to transfer it to.

3. Mortgage rates might come down. As I mentioned above, mortgage rates aren’t closely tied to the fed rate. However, if you are thinking about buying a house or refinancing your mortgage, it’ll be prudent to keep an eye on the proffered rates. They are likely to come down somewhat, and getting even a small rate reduction can make a difference, considering the amount you’ve borrowed. For instance, a savings of half a percent on a 30-year, $300,000 mortgage will save you about $85 per month.


4. Home Equity Lines of Credit (HELOC) rates will likely be reduced. HELOCs are usually linked to the prime rate, which means the Fed’s rate cut will probably reduce interest rates for any homeowners who have outstanding balances on their HELOCs. This also means it’s potentially a good time to shop for a HELOC if you’re interested in one.


5. Auto loans will likely lower their rates. Auto lenders are often influenced by fed rates in determining their interest rates. If you are in the market to buy a car, this could mean a more favorable interest rate.


Remember: It’s All Imaginary

So, Jerry-Pow-Pow lowered the rates over the weekend to try to stabilize the economy. Considering all the terrifying stuff going on right now, that probably doesn’t sound especially comforting. The head of a government office whose job it is to keep the economy chugging along lowered rates about as low as they can go. It’s okay if you need to feel a little concerned about that.


But here’s the comforting part, even if it doesn’t sound comforting immediately: all of this is imaginary. Money’s not real and the federal funds rate is in many ways arbitrary. None of this is “real” in the same way that you, your family, and your health are real. This just happens to be the arbitrary system we’re using.


However, even though money is imaginary, there are some real and concrete things you can do to make sure you survive and thrive within this weird system of imaginary number friends:


1. Be consistent about your good financial behavior. That includes setting money aside in an emergency fund and investing in your retirement. Committing to the consistent behavior (and even better, making it automatic) means you have money set aside when you need and can ride out market fluctuations without turning a hair.


2. Take your time making money decisions. There has never been a single instance wherein someone said “I’m so glad I made that financial decision in a rush and while feeling acute panic.” Good money decisions generally take time or forethought. Forcing yourself to slow down when you’re tempted to jump into something will never go amiss—which is true of everything from investments to tattoos, and don’t ask me how I know that.


3. Remember that you, not your money, can handle whatever life throws at you. We often long for a sense of financial security—the sensation that our money can handle any catastrophe. But you, rather than your money, is the one that can handle whatever comes.


You are in the driver's seat, not your money.

Money is just a tool (and an imaginary one at that!). You are the one in control and you can handle it, whether or not money is one of the biggest tools in your toolbox.

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© 2020 by Emily Guy Birken