Thursday, 29 October 2020

What Happens After a Fed Rate Cut

What Happens After a Fed Rate Cut
26 Jul
5:54

For the first time in over a decade, we are looking at the very real possibility of a Federal Reserve rate cut. The Federal Open Market Committee (FOMC) has not cut rates since back in December 2008, which saw the final cut in a campaign of ten interest rate reductions, designed to help end the worldwide economic chaos of the 2008 financial crisis.

In September 2007, the Fed dropped the fed funds target range from 5.25% to 4.75%, then slashed rates nine more times over the course of 15 months, finally ending in December 2008 by reducing fed funds to a historically low range of 0% to 0.25%. It left rates unchanged for seven years, until a small hike to 0.25% to 0.50% in December 2015. This kicked off a string of rate hikes that ended last December, when the FOMC raised the federal funds rate to 2.25% to 2.50%.

We’ve been on pause since the January meeting, holding our breath as the consensus among economists and Fed watchers has fluctuated between calls for another rate hike and now a possible rate cut.

What is the federal funds rate?

The federal funds rate is the Federal Reserve’s main tool for managing interest rates in the United States. Fed funds is the main benchmark for the interest rates on every financial product on the market, including savings accounts, personal loans, mortgages and credit cards.

To put it more precisely, the federal funds rate is the narrow range of interest rates at which banks and credit unions trade federal funds — the balances they hold at Federal Reserve Banks — with each other overnight. The effective federal funds rate is the weighted average of the rates that banks negotiate with each other. Financial institutions use the effective federal funds rate as the benchmark for setting interest rates on all of their other lending and deposit products.

When the federal funds rate goes up, interest rates on financial products also go up. So when the federal funds rate is high, savers rejoice because it means better returns on their deposit accounts. But it also means it’s more expensive for consumers and businesses to borrow money, putting downward pressure on economic activity and inflation, the Fed’s main enemy. It also makes it harder for borrowers to get loans when APRs are higher.

And when the federal funds rate goes down, institutions lower their rates, enabling consumers and businesses to borrow more money at lower rates, thereby driving more economic activity. On the other hand, those looking for the best savings rates, including the best rates on certificates of deposit (CDs), will be disappointed as deposit account rates fall.

What happens after a Fed rate cut?

A Fed rate cut will cause a downward shift in deposit account rates. We’ve already been experiencing industry-wide interest rate cuts on savings and other deposit account types, and that’s only because of the pause in rate policy rather than a real cut.

“If the Fed does cut rates, I think we’ll see many online banks react within a few weeks,” predicted Ken Tumin, founder of DepositAccounts.com, also LendingTree-owned. “The average online savings account rate cut will probably follow close to the Fed rate cut (most likely 25 basis points) within a month or two.”

As for brick-and-mortar bank rates, they’ll also see small drops, but since their rates are already so low, their bottom line will hardly be affected.

How a Fed rate cut affects certificates of deposit (CDs)

Looking at historical CD rates confirms that we can expect deposit account interest rates to drop soon after a cut is announced. Tumin recalls that the rate cuts came quickly after the Fed cut rates in 2007. This was especially true for certificates of deposit, which tend to follow the federal funds rate rather closely. Back then, amid the financial crisis, rates followed until CD rates dropped below 2%, while savings accounts were earning less than 1%.

Below, you can see how closely the average 6-month CD rate followed the federal funds rate until the chaos of the financial crisis peak.

This time around, we’ll probably see more rate cuts like we’ve already been seeing for CDs. However, it’s more important to keep an eye on the Fed’s future outlook for the federal funds rate to determine where CD rates are going.

“If the Fed paints a deteriorating picture of the economy, that will increase the odds of several more rate cuts to come,” Tumin said. “That will put more downward pressure on CD rates, especially the longer-term ones like the 3-, 4- and 5-year CDs.”

How a Fed rate cut affects your credit card and mortgage

A Fed rate cut can help you pay off your credit card bills. Most major credit card issuers will lower their APRs accordingly within one or two billing cycles.

“It won’t move the needle much if [the Fed] only [cuts rates] once — since it’s only 0.25% — but any reduction is helpful when you have credit card debt,” said Matt Shulz, senior industry analyst at CompareCards, another LendingTree-owned site. Lowering your credit card’s variable rate means your credit card balances will accrue less in interest, possibly making it easier to pay down.

A lower federal funds rate will also affect adjustable-rate mortgages and HELOCs, as they’re based on short-term rates. “These should decline in tandem with the federal funds rate,” said Tendayi Kapfidze, lead economist at LendingTree.

Fixed-rate mortgages are less affected by the federal funds rate, instead tracking the 10-year Treasury rate. “A Fed funds cut will likely have little impact on fixed mortgage rates at this point,” Kapfidze said.

Why is the Fed cutting rates?

The Fed looks closely at several factors when considering whether to raise or cut the federal funds rate, including wages, employment, consumer spending and global markets. If the data points to a strong, growing economy, when employment is high and inflation is stable, the Fed may choose to raise the federal funds rate. Again, because that tightens access to money, it tends to slow down growth and prevent overheating. It also helps people save their money more efficiently in their savings accounts.

At the moment, however, we’re seeing the economy’s growth slowing down all on its own. Reports around jobs, spending and wages, paired with the current uncertainties surrounding global trade, have indicated to experts and undoubtedly, the Fed, that the economy is in need of a boost.

“A lower federal funds rate is seen as helpful to the future health of the economy,” Tumin said. A Fed rate cut, after months of weakening data, would hopefully breathe life back into the economy.

Note: This article includes links to DepositAccounts.com, which is also owned by LendingTree.

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Lauren Perez

Lauren Perez |

Lauren Perez is a writer at MagnifyMoney. You can email Lauren here

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Source: https://www.magnifymoney.com/blog/banking/fed-rate-cut/

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