Over the last few months in the finance world, there has been a lot of talk about the Federal Reserve System (Fed) “raising rates.” However, we often don’t know what that means or exactly what affect that will have on our portfolios. In this article, I will shed a bit of light on what it means to raise rates and why this happens.
First, it is important to understand the mandate the Fed has from the government. The Fed has two mandates; one is to maintain maximum employment in the economy, and the second is maintaining stable prices and moderate long-term interest rates. Maximum employment is not 100% employment, but simply maintaining a rate of employment that would be natural in normal economic times. Stable prices is just what it sounds like; the Fed tries to maintain an inflation rate of 2% so that individuals and businesses can make long-term decisions safely.
The second thing we need to know is how the Fed actually raises rates. The Federal Reserve System, also known as the central bank, is in charge of conducting monetary policy. One way they do that is to change the interest rate on the federal funds for overnight loans. Financial institutions in the U.S. are required to retain a certain proportion of liquid funds, think cash, of their overall capital. This is to ensure they can pay out to their members if members want their money back.
Sometimes financial institutions lend out too much money during the day, so at night, to maintain their liquidity, they have to borrow money from either other banks, or the Fed. This is where the federal funds rate comes in. When the economy is slow and needs a boost, the Fed sets their federal funds rate at around 0% which means banks can borrow for essentially free. In turn, they can lend that money out for lower interest rates making loans cheaper. However, when the economy starts to run too hot and inflation starts to rise, the Fed raises their rates, which causes banks to raise their rates.
This may affect you through your loans and cards first. As Fed rates rise, so will the interest rates for new loans on homes, cars, credit cards, and more. The best thing to do is review any debt you have with a variable interest rate to know what might be impacted. This might encourage you to pay off as much revolving debt (credit cards) as you can because those rates are variable and you could end up paying more later. Another option is considering a personal loan to pay off credit card debt because personal loans usually have much lower rates than credit cards and they are fixed.