How A Cut to the Fed Funds Target Rate Can Affect Your Bottom Line
Steve Brown
October 30, 2007
Those who have not done a great deal of study in the area of economics might wonder why just a hint of a possible adjustment to the U.S. fed funds target rate can be the source of front page news all over the globe. The target fed funds rate, which is America’s benchmark interest rate and is controlled by the Federal Reserve’s Federal Open Market Committee (FOMC), and can have a very real and lasting impact on the finances of all classes of Americans.
The most recent adjustment by FOMC, in September 2007, was just a cut of one half of a percentage point, a change that might seem rather insignificant to the average consumer. Yet, now that another FOMC monetary policy meeting is approaching (set to convene on October 30, 2007 and adjourn the day after), speculation on whether another cut of 25 basis points (0.25 percentage point) will be made is rampant throughout the financial world.
Positive Economic Effects
The FOMC’s fed funds target rate reduction in September was the first such cut to be made to this key short-term interest rate since June of 2003. While many analysts had predicted a drop, the adjustment made by the FOMC was twice what they expected, moving the target federal funds rate from 5.25 percent to 4.75 percent. This rather radical adjustment was widely perceived as an attempt to ease the affects of declining home values, financial market turmoil and the subprime foreclosure crisis on the economy.
The chief reason the September rate cut, and expectations of another on Halloween, is the source of such intense discussion in the financial world is that it has an indirect affect on a broad range of key economic sectors. The stock market generally rises on the news of a rate cut by the Federal Reserve, quite often just on the rumor of one. After the September rate cut, the Dow Jones industrial average ended the day with a rise of 355 points, a 2.51 percent increase.
As the federal funds rate goes down, the U.S. Prime Rate invariably follows. The Prime Rate is used as an index or base rate for a variety of short-term loans, like many auto and education loans, and for some adjustable-rate mortgages. Most business and consumer credit cards have a variable interest rate, and the vast majority of variable-rate credit cards are indexed to Prime. So, in real-world terms, adjustments to the target fed funds rate ripple through the economy and reach consumers at many levels.
Economic Drawbacks
Certificates of Deposit, a popular low-risk savings vehicle, are generally tied to the fed funds target rate. When the Fed lowers the fed funds rate target, the return on these investments also tends to drop.
Bond markets are affected by interest-rate cuts as well, most often shifting in the opposite direction of stock market activity. Yields on many bonds, like U.S. Treasuries, tend to travel downward when interest rates are reduced, another blow to the conservative savers among us.
An increase in the rate of inflation is quite often the result of interest rate cuts, as cheap money flows into the economy. For the average consumer, this translates into higher prices for the basics of daily life, like food, clothing, energy, and housing.
Rising inflation hastens the devaluation of our currency, lowering its purchasing power domestically, and decreasing its value against the currencies of our international trading partners. Current figures show the dollar at its lowest point in eight years when compared to the euro.
This dollar decline makes imported products more expensive for American consumers and businesses that depend on overseas supplies. The falling value of the dollar is also reflected in the prices of such commodities as gold and crude oil. Both have reached record prices in recent days, gold hitting an astounding high of $800 an ounce, and crude futures for December delivery recently closing at a record $93.53.
The FOMC will meet on October 30-31. Many economists are predicting another fed funds target rate decrease at this meeting, with most expecting rates to go down by another quarter-percentage point. One of the greatest challenges FOMC members face in today's economic climate is finding a healthy balance between mitigating the effects of the housing slump, subprime meltdown and financial market liquidity crunch, while at the same time keeping core inflation within the Fed’s comfort zone of 1% to 2%.
The business and finance headlines are not just for those in industries related to economics. While the world of big business and high finance may seem quite distant to the average person, the fact of the matter is that what happens in these realms does trickle down to affect the day-to-day life of consumers. Understanding these connections can help the average consumer compensate for the economic ebb and flow that’s a natural part of the business cycle, and thus help to protect one’s assets and financial wellbeing.
The most recent adjustment by FOMC, in September 2007, was just a cut of one half of a percentage point, a change that might seem rather insignificant to the average consumer. Yet, now that another FOMC monetary policy meeting is approaching (set to convene on October 30, 2007 and adjourn the day after), speculation on whether another cut of 25 basis points (0.25 percentage point) will be made is rampant throughout the financial world.
Positive Economic Effects
The FOMC’s fed funds target rate reduction in September was the first such cut to be made to this key short-term interest rate since June of 2003. While many analysts had predicted a drop, the adjustment made by the FOMC was twice what they expected, moving the target federal funds rate from 5.25 percent to 4.75 percent. This rather radical adjustment was widely perceived as an attempt to ease the affects of declining home values, financial market turmoil and the subprime foreclosure crisis on the economy.
The chief reason the September rate cut, and expectations of another on Halloween, is the source of such intense discussion in the financial world is that it has an indirect affect on a broad range of key economic sectors. The stock market generally rises on the news of a rate cut by the Federal Reserve, quite often just on the rumor of one. After the September rate cut, the Dow Jones industrial average ended the day with a rise of 355 points, a 2.51 percent increase.
As the federal funds rate goes down, the U.S. Prime Rate invariably follows. The Prime Rate is used as an index or base rate for a variety of short-term loans, like many auto and education loans, and for some adjustable-rate mortgages. Most business and consumer credit cards have a variable interest rate, and the vast majority of variable-rate credit cards are indexed to Prime. So, in real-world terms, adjustments to the target fed funds rate ripple through the economy and reach consumers at many levels.
Economic Drawbacks
Certificates of Deposit, a popular low-risk savings vehicle, are generally tied to the fed funds target rate. When the Fed lowers the fed funds rate target, the return on these investments also tends to drop.
Bond markets are affected by interest-rate cuts as well, most often shifting in the opposite direction of stock market activity. Yields on many bonds, like U.S. Treasuries, tend to travel downward when interest rates are reduced, another blow to the conservative savers among us.
An increase in the rate of inflation is quite often the result of interest rate cuts, as cheap money flows into the economy. For the average consumer, this translates into higher prices for the basics of daily life, like food, clothing, energy, and housing.
Rising inflation hastens the devaluation of our currency, lowering its purchasing power domestically, and decreasing its value against the currencies of our international trading partners. Current figures show the dollar at its lowest point in eight years when compared to the euro.
This dollar decline makes imported products more expensive for American consumers and businesses that depend on overseas supplies. The falling value of the dollar is also reflected in the prices of such commodities as gold and crude oil. Both have reached record prices in recent days, gold hitting an astounding high of $800 an ounce, and crude futures for December delivery recently closing at a record $93.53.
The FOMC will meet on October 30-31. Many economists are predicting another fed funds target rate decrease at this meeting, with most expecting rates to go down by another quarter-percentage point. One of the greatest challenges FOMC members face in today's economic climate is finding a healthy balance between mitigating the effects of the housing slump, subprime meltdown and financial market liquidity crunch, while at the same time keeping core inflation within the Fed’s comfort zone of 1% to 2%.
The business and finance headlines are not just for those in industries related to economics. While the world of big business and high finance may seem quite distant to the average person, the fact of the matter is that what happens in these realms does trickle down to affect the day-to-day life of consumers. Understanding these connections can help the average consumer compensate for the economic ebb and flow that’s a natural part of the business cycle, and thus help to protect one’s assets and financial wellbeing.