n personal finance, the conversation often focuses on things within our control including: spending habits, how much we invest, etc.
However, it’s also important to recognize the ‘8.1 Trillion Dollar Gorilla in the Room.’ I’m talking of course about the Federal Reserve (commonly referred to as The Fed).
In a nutshell, The Fed is responsible for implementing monetary policy measures in order to maintain the stability & health of the nation’s economy. Today, we’ll be talking about how two of their policy decisions (federal funds rate & quantitative measures) can impact our day-to-day finances.
Let’s dive in!
Introduction to The Fed’s Toolbox
Federal Funds Rate
The policy measure that gets the most media attention is the federal funds rate.
Set by the Federal Open Market Committee (FOMC), the federal funds rate is the interest rate that financial institutions use when they are lending money to each other. This interest rate effectively serves as the baseline for many other interest rates in our economy, including the prime rate.
The prime rate is the interest rate that financial institutions offer their most creditworthy customers. Whether we are talking credit cards, mortgages, personal loans, car loans… these consumers rates are effectively based off the prime rate.
All else being equal, if The Fed raises the federal funds rate, the prime rate tends to increase, which in turn makes loans/debt more expensive. Similarly, if The Fed lowers the federal funds rate, the prime rate tends to decrease, leading to loans/debt becoming less expensive.
Quantitative Measures
Equally important as a policy tool, The Fed also has two types of quantitative measures at it’s disposal that can be employed to manage it’s balance sheet.
The first of these measures is Quantitative Easing (QE). QE involves The Fed purchasing financial assets in the open market to inject money into the economy, thereby stimulating lending and other economic activities. The objective is to increase the overall money supply and enhance market liquidity. QE gained significant prominence during the 2007-2008 financial crisis.
On the other end of the spectrum is Quantitative Tightening (QT). QT involves The Fed selling financial assets in the open market and/or allowing the securities they hold to mature, with the goal of decreasing the money supply and market liquidity. QT is a strategy employed to counteract high inflation.
How The Federal Funds Rate Impacts Our Finances
Saving Account’s APYs
As of this writing, The Fed has been slowly increasing the federal funds rate since March 2022.
What does this mean for us as consumers?
Well, the federal funds rate exhibits a moderate positive correlation with the interest rates offered by various savings accounts. In broad terms, this implies that when the federal funds rate rises, there is often a corresponding increase in the Annual Percentage Yields (APYs) offered by financial institutions for savings accounts (the reverse is also true).
One of the significant impacts of this is offering savers better protection against the inflationary pressures that have occurred over the last several years. This is particularly positive news for individuals saving cash for short-to-medium-term goals, as their savings can maintain more of their ‘real value.’
Spending & Loans
Changes to the federal funds rate can indirectly result in changes to our overall spending and appetite for taking on more debt. As we mentioned earlier, the federal funds rate tends to have a positive correlation with the prime rate.
And from a consumer perspective, the prime rate can have a rippling impact on the economy.
A lower prime rate frequently leads to reduced interest rates across a range of financial products, including but not limited to mortgages, credit cards, and automobile loans, which in turn can create higher demand. Conversely, a higher prime rate can decrease overall consumer demand due to:
1) Less credit approvals as a result of tighter credit requirements by financial institutions
2) Decrease in consumers applying for more expensive financing
Individual Investment Portfolios
The federal funds rate can also impact our investment portfolios by influencing the growth rate of various investment classes.
When interest rates are lowered, businesses have increased access to more affordable financing options. This can result in businesses increasing their spending and investment, which has the ability to bolster their earnings and by extension companies’ stock performance.
By the same token, higher interest rates may result in businesses pausing or limiting additional spending and investment due to the lack of affordable long-term financing. This can result in slower company growth.
Furthermore, a lower interest rate environment can make fixed-income investments such as bonds much less attractive. This can translate in more investors investing in riskier asset classes such as individual stocks in order to achieve higher returns. Over time, this can lead to the stock market rising and increased growth in individual equity-focused portfolios.
Similarly, higher interest rates often shift investor preferences towards fixed-income investments rather than common stocks. Over the long term, this shift can result in the growth of individual debt-focused portfolios.
How Quantitative Measures Impact Our Finances
Quantitative Easing
One of the most noticeable effects of QE is its influence on interest rates.
This increased money supply often leads to lower interest rates on loans. The result is borrowing becoming much more affordable and potentially enabling us to make major purchases that we may have not otherwise been able to afford.
However, the flip side of this situation is that QE can result in lower returns on conservative investments like savings accounts, certificates of deposit (CDs), and government bonds. This can be a challenge for individuals who rely on these types of investments for steady income, such as retirees.
Finally, another impact of QE is its potential to contribute to inflation.
As The Fed injects more money into the economy, this can lead to an increase in overall demand for goods and services. However, if supply doesn’t keep up with this heightened demand, prices can tend to rise, resulting in inflation. The concern here is that excessive inflation can erode our purchasing power over time, impacting our ability to afford everyday goods and services.
Quantitative Tightening
Similar to QE, QT can also have a noticeable effect on interest rates.
As a reminder, the idea is to decrease the overall money supply and liquidity in the markets. This reduction of the money in circulation generally causes interest rates to rise and borrowing become more expensive. This can be a major turn off for those who are in need of financing when considering major purchases (mortgages, auto loans, etc.).
Furthermore, QT can also influence the performance of specific investment classes. More specifically, fixed-income investments (such as bonds) tend to become more attractive relative to riskier asset classes like common stock. This shift in investor behavior can have broader implications for the stock market’s performance relative to the bond market.
Final Thoughts
While it is easy to view ‘The Fed’ as an ominous entity that we will occasionally see in the headlines, the truth is that the decisions they make can have broad-sweeping impacts to our personal finances.
By having a better understanding how we can be impacted, we can do a better job planning how to react to these decisions in order to optimize our own personal finance strategies.
Thank you for reading.
Disclaimer: Nothing in this article should ever be considered advice, research or an invitation to buy or sell securities. I am not a financial advisor.
https://www.nasdaq.com/articles/how-the-fed-impacts-our-personal-finances
