Today, the news is abuzz about the Fed raising interest rates by 75 basis points, or 0.75 percent. It’s the same amount it raised interest rates by in June and is the first time ever that two 0.75 percent rate hikes have occurred so quickly. The steep interest rate hikes result from America facing record-high levels of inflation (rising prices) not seen in 40 years. While most consumers have been painfully aware of rising prices on everything from groceries to automobiles, there may be some confusion about the rest of the story!
Who is The Fed?
We frequently hear about “The Fed” in the news, usually regarding interest rates. “The Fed” is shorthand for the Federal Reserve System, the government regulatory agency (in this case, a central bank) that controls monetary policy by adjusting interest rates. While those may seem like highly technical terms, they’re actually pretty straightforward:
- Regulatory agency: A government agency that sets rules and regulations for specific industries, usually in complex or technical subjects. Regulatory agencies have a great degree of independence from Congress and the President in conducting their jobs, which minimizes political pressure. These agencies are often staffed by experts in that specific field and use lots of data and research to make decisions on regulations.
- Central bank: A government-controlled bank that oversees commercial banks, which are the banks that individuals and businesses use. Central banks are often lenders of last resort, meaning they can lend money to commercial banks in times of financial crisis to ensure that people can continue spending money.
- Monetary policy: Controlling the money supply to affect the value and availability of money. When an economy is in a recession (period of decline), monetary policy is adjusted to make borrowing money easier. This is intended to boost spending. When there is too much inflation (rising prices), monetary policy is adjusted to make money more difficult to borrow. This reduces spending and, hopefully, reduces inflation.
- Interest rates: The “price” of borrowing money. When money is borrowed, it must be paid back with an extra fee. This fee is the interest. When interest rates are low, borrowing money is a comparatively better deal, so people tend to borrow more. When interest rates are high, borrowing money costs more, so people tend to borrow less.
The Fed was established in 1913 after the infamous 1907 banking crisis. Unlike most other nations, America’s central bank is composed of twelve regional Federal Reserve Banks (FRBs). The leaders of these banks meet in committees to determine monetary policy actions. Their collective goal is to adjust monetary policy to provide for low inflation and unemployment. This is accomplished through setting interest rates, setting rules and regulations for commercial banks, and authorizing the printing and distribution of currency.
How Does The Fed Affect You?
Although you don’t bank at the Fed, you do bank at one of the thousands of commercial banks or credit unions (nonprofit banks, usually smaller than commercial banks) directly affected by the Fed. When the Fed adjusts interest rates, which it just did today, it has a “trickle down” effect throughout the banking system (also known as the banking industry). There are many different interest rates, and they have a “trickle-up” effect as they get closer to the consumer (you) and further from the Fed. There are three basic interest rates:
- Federal funds rate: This is the target interest rate pursued by the Fed. This is the one when you see news about the Fed changing rates. It is based on the money supply and is the interest rate that commercial banks charge each other for short-term loans. It is a goal of the Fed, but can only be changed indirectly through changes in the money supply.
- Discount rate: This is the rate the Fed charges commercial banks for loans. It is directly adjusted by the Fed and is higher than the federal funds rate to discourage banks from always borrowing from the Fed itself.
- Prime rate: This is the best interest rate received by non-bank borrowers. Unfortunately, it is always higher than both the federal funds rate and the discount rate. Typically, it is only available to large companies with a track record of paying off all [large] loans on time. So, even if your credit score is awesome, you will have an interest rate higher than the prime rate.
So, when you go to your bank or credit union to take out a loan, your interest rate is a direct “trickle-up” from whatever the Fed has set as its target interest rate. With the Fed raising the target interest rate by a record amount in two months, the interest rate you receive on any loan will be somewhat higher than it was in the spring.
So, What Can I Do About Higher Interest Rates?
While there is no way for an individual borrower to bring down interest rates in general, a borrower can receive a lower interest rate on their loan by doing two things:
- Have a good credit score: Your credit score is the average of the scores your receive from the three main credit bureaus: Equifax, Experian, and TransUnion. These companies track your credit reports, which are reports of how well you have paid off bills, loans, and other financial obligations. Your credit report looks at your payment history regarding bills, if you have any outstanding debt, how long you have been paying bills, and your “mix” of types of bills and loans. When interest rates are high, you want a good credit score (preferably over 700), so your bank will give you a lower interest rate. People with low credit scores are charged higher interest because they are considered more likely to not make all the payments on time.
- Borrow as little as you can: Larger loans have higher interest rates. Therefore, it’s a good idea to budget carefully and only borrow the amount you truly need. Taking out a loan for a larger amount “just in case” will likely stick you with a higher interest rate…which will be applied to the entire principal (dollar amount you borrowed). This means you will have to work harder and longer to repay the loan, especially when the Fed has raised interest rates overall.