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The fluctuation of interest rates by the Federal Reserve has grabbed the attention of a significant number of US citizens this year. These rate fluctuations have had a detrimental impact on personal finances, as well as influencing inflation and creating volatile costs for goods and services. In this article, we will explore how the Federal Reserve's interest rate manipulation can influence various aspects of your financial situation, such as borrowing costs, savings, investments, and overall economic stability.
What is the Federal Reserve?
The Federal Reserve (or “The Fed”) is the primary monetary authority in the United States and manages the national money supply. It does this primarily by buying and selling securities on the open market, but it also sets the federal funds rates that financial institutions pay to obtain funds.
For example, if the Federal Reserve wants to decrease the money supply (to slow down the economy and combat inflation), they sell government securities like U.S. Treasury Bonds to financial institutions, effectively removing that money from circulation. When they want to increase the money supply (to increase liquidity and promote spending), they buy U.S. Treasury Bonds, thereby injecting more cash into the economy.
Another way that the Federal Reserve controls the money supply is by raising and lowering federal funds rates — the interest rate that depository institutions (like banks) pay to borrow money. These decisions trickle down to consumers ultimately having a major impact on the interest rates that individuals pay.
Interest Rate Manipulation
While the Federal Reserve does not lend directly to individual consumers, their interest rates can still have a major impact on your financial planning. The Federal Reserve typically adjusts the federal funds rate very slowly over time, but each small change can have a major impact on your finances.
How the Federal Funds Rate Impacts Your Interest Rates
With each Federal Reserve interest rate hike, banks pay a higher interest rate to obtain funds. Since banks have to maintain enough liquidity to continue funding loans and withdrawals, they charge higher interest rates to their customers, including you.
After over a year of hovering around 0%, the Effective Federal Funds Rate (EFFR), or the actual average rate that banks pay to obtain funds, jumped from 0.08% in February 2022 to 5% just over a year later in May 2023. In that same period, mortgage rates nearly doubled as they climbed from 3.5% to 6.5%, peaking above 7% in Q4 2022.
Let's consider a scenario of an individual looking to purchase a house during the period of interest rate fluctuations:
Suppose they want to take out a mortgage loan of $250,000 with a 30-year term.
In February 2022, when the Effective Federal Funds Rate (EFFR) was approximately 0.08% and mortgage rates were around 3.5%, their monthly mortgage payment would be approximately $1,122.61.
Fast forward to May 2023, when the EFFR has increased to 5% and mortgage rates have risen to 6.5%. If they were to secure a mortgage at that time, their monthly payment would be around $1,579.57.
As a result of the interest rate fluctuations, the monthly mortgage payment would increase by approximately $456.96. Over the course of the 30-year loan term, this would amount to an additional cost of approximately $164,505.60.
How Interest Rate Hikes and Dips Affect Inflation
The Federal rate hikes and dips have a direct effect on the interest rates you get from your bank, but they also impact you indirectly through inflation. The average costs of goods and services increase as inflation goes up.
The Federal Reserve is similar to a dam that must carefully regulate the amount of water that’s allowed to leave a reservoir. When the dam releases no water, it produces no energy and creates a drought. When the dam releases too much water, it causes flooding and can lead to its own collapse.
The Federal Reserve has the power to influence the money supply, and by doing so, it can impact the overall economy. When the Fed restricts the flow of money (via increased interest rates or other means), it can indeed slow down economic growth. This can help mitigate inflation because when money is less available, there's less demand for goods and services, which can put downward pressure on prices.
While the Federal Reserve does its best to balance the two extremes, any small hike or dip in its federal funds interest rate can affect individual consumers.
Interest Rates and You
Understanding the impact of interest rates on our financial well-being is crucial, whether we're navigating periods of high or low inflation. To ensure a secure financial future, it's vital to explore protective strategies during inflation and seize opportunities when inflation is low.
During periods of fluctuating interest rates, individuals often find it challenging to fulfill their life goals due to the adverse effects on their overall financial wealth.
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