Are you wondering how the Federal Reserve interest rates impact your life? Probably not... But you should. Interest rates impact everything that you do related to money.

This week we are discussing how the Federal Reserve's actions effect interest rates, inflation and deflation. We discuss why they manipulate interest rates, how this can effect your money, and what the Federal Reserve fears most (hint, its not ghosts).

How Many Works: How the Federal Reserve Impacts Investors

Authored by: David Stein

We often hear how the Federal Reserve just cut interest rates and perhaps the stock market rallied because it did so. Who is the Federal Reserve, what does it mean that they cut interest rates, and how does it impact you as an individual investor?

What Central Banks Do

The Federal Reserve is the U.S. central bank. It is also called “the Fed” for short. The Fed was created in 1913 when President Woodrow Wilson signed the Federal Reserve Act into law.

Most countries and regions have central banks. Examples include the Bank of England, the Bank of Japan and the European Central Bank. The purpose of central banks is to ensure stability in the financial system. That means making sure there is not too much inflation, which measures the rise in prices over time. Financial stability also means the economy is growing, but not too quickly since a rapidly expanding economy can lead to inflation. 

The Dual Mandate

The U.S. Congress has given the Federal Reserve two primary objectives: ensure stable prices and full employment. The primary way the Federal Reserve seeks to accomplish this dual mandate is through its monetary policy, which are actions the Fed takes to influence interest rates. For example, as part of its monetary policy, the Fed sets a target for very-short-term interest rates such as the interest rate it pays on deposits commercial banks hold at the Federal Reserve. Another short-term interest rate target is the Federal Funds rate, which is the interest rate that banks charge to lend money to each other overnight.

When the financial media says the Federal Reserve cut interest rates they are referring to the central bank lowering the Federal Funds target rate as well as the interest rate the Fed pays on deposits held at the central bank, which are known as reserves. 

How the Fed Influences Longer-term Interest Rates

While the Federal Reserve typically only directly controls short-term interest rates, its actions can also influence longer-term rates. A long-term interest rate can be decomposed into a series of short-term rates. For example, you could choose to borrow money for five years or you could take out a loan for one year and then refinance it every year for 5 years. Or if you could find a lender, you could take out a loan and refinance it every month for five years. There are even some businesses that borrow money for one day and refinance the loan every single day.

Because borrowers and lenders have the flexibility to choose their time frame for lending and borrowing, the level of long-term interest rates is directly influenced by households’ and businesses’ expectations for short-term interest rates. The biggest driver of those expectations is what central banks are doing with regards to monetary policy. Is the Federal Reserve lowering short-term interest rates and communicating that it will continue to do so? Or is the Fed increasing short-term rates? The short-term interest rate along with expectations for future short-term rates influences longer-term rates, which in turn influences how much households and businesses want to borrow. Lower interest rates encourage more borrowing while higher interest rates encourage less.

How the Federal Reserve Chooses the Level of Short-term Interest Rates 

Currently, short-term interest rates are about 1.5% in the U.S. while in other countries short-term rates are close to zero. Central banks set short-term interest rates at a level that approximates what is known as the neutral rate of interest. This is an unobservable interest rate or a theoretical rate. Central banks believe this neutral rate of interest is low enough to encourage businesses to borrow money to invest in new projects including hiring more workers. It is also the interest rate that motivates households to borrow to buy a new home or buy a car, which can keep construction and manufacturing workers employed. In other words, the neutral rate of interest is the rate of interest that ensures everyone that wants a job can get a job and that the economy continues to expand, but not at a pace that leads to too much inflation. The Federal Reserve sets a target for short-term rates that it believes matches the unobservable neutral rate of interest, which is the rate the Fed believes will ensure financial stability.

Additional Interest Rate Drivers

There are two other factors that influence the level of interest rates. The first is inflation expectations. When lending money, if investors and banks believe inflation will be higher in the future then they will want additional compensation in the form of higher interest rates to protect them against that loss of purchasing power.

In addition, if investors and banks are uncertain regarding future central bank actions or future inflation then they will want a higher interest rate to compensate for that uncertainty. That additional compensation is called a term premium.

These three factors: future short-term interest rate expectations, inflation expectations, and the term premium are the theoretical basis for the level of interest rates. Of course, the actual level of interest rates is set in the market based on the willingness of banks and investors to lend and the willingness of households and businesses to borrow.

How the Federal Reserve Impact Investors

Actions by Federal Reserve and other central banks can influence interest rates as individuals adjust their expectations based on what central banks say and do. In turn, fluctuating interest rates impact the prices and returns of numerous asset classes including bonds, stocks, and real estate. 

Extended periods of low interest rates like we have seen in the past decade mean investors earn less on their conservative investments such as savings accounts, bank certificates of deposits, and short-term bonds. Those low interest rates push individuals saving for retirement to save more while motivating retirees to spend less or find other ways to generate additional income.

Given the significant influence the Federal Reserve and other central banks have over interest rates, financial markets and the economy it is important that as individual investors we stay aware of what central banks are doing.