You may have seen news about the Fed raising interest rates…but what exactly does that mean? How does that affect the economy? And more importantly, how does it affect YOU?
Today, I’m going to break down everything you need to know about the rising interest rates so you can make the best financial decisions in this current economic climate.
So, get ready to take notes – We’re covering a lot of ground.
What’s the Federal funds rate?
Basically, banks that accept deposits from people are required to keep a certain amount of money on hand in case people want to make withdrawals. This amount of money is determined by the total amount of money deposited at the bank.
But the amount of money at the bank fluctuates as people go about their day, making deposits and withdrawals. If a bank thinks that it’s going to be over the amount of money it needs to have on hand, it can lend money to another bank that thinks it’s going to come up short.
The interest rate banks charge each other on these loans is called the effective federal funds rate.
Why is the Fed raising interest rates?
Eight times a year (or more, if the economy is REALLY a mess), the Federal Open Market Committee — a group of people from the Fed in charge of setting monetary policy — meets to decide what the ideal federal funds rate should be.
To make things a little more complicated, the Federal Reserve (or “the Fed”) doesn’t set the federal funds rate; that’s decided by the banks. But the FOMC sets a target federal funds rate between a certain range.
So, let’s say that the FOMC sets the target federal funds rate upper limit at 2.5%. This means that a bank can’t set the effective federal fund rate higher than that.
In order to get that into the target range, the FOMC either adds money into the financial system, which increases supply and lowers the effective rate, or they take money out of the system, which decreases supply and increases the effective rate.
The Fed sets the target federal funds rate based on the health of the economy.
For example, let’s look at what’s been happening in recent years.
While the pandemic was at its worst, the rate was at 0% as a lot of people and businesses were struggling financially. But since then, inflation has spiked – in fact, it hit its highest point in the last 40 years.
Put simply, inflation is a decrease in the spending power of money. For instance, something that cost $5 a year ago may now cost $8, meaning that your $5 bill can buy less than it could a year ago.
Moderate inflation is generally considered normal and can be a sign of a healthy economy. However, when inflation becomes too high and too rapid, it can erode the purchasing power of consumers and disrupt economic stability.
To offset this, the Fed has increased interest rates to record highs.
Basically, what the Fed aims to do when it increases rates is to force a slowdown in economic activity. Remember, all of economics relies on the law of supply and demand – when demand is high and supply is low, prices are high. But when supply is high and demand is low, prices are lower.
The Fed is hoping for a domino effect: when borrowing and spending decrease, businesses produce fewer goods and services, which can alleviate the skyrocketing prices caused by excessive demand.
The Fed typically raises interest rates gradually, in a series of small steps, to avoid causing economic disruptions. It carefully monitors economic indicators and adjusts its policies as needed.
That’s what we’ve seen; most increases take place in 0.25% increments, so it can take time for the Fed to reach a level where the interest rate makes a satisfactory difference.
It can also take time to see the impact on the economy. In fact, it may take several months or even years for these policy actions to fully affect inflation.
In the meantime, you may be wondering…
How does this impact you?
As I said, the overarching goal is to bring down inflation. But in the meantime, here are a couple of key things to be aware of as you make financial decisions:
1) You could pay more for debt
While the interest rate on savings products are going up, unfortunately, that also means that the interest rate on debt is likely going up.
Now, if you’re already locked into a good rate, you’re fine. But this is probably a bad time to refinance.
Plus, if you’re looking to finance a mortgage or car loan, then your options may be discouraging. If that’s your situation, don’t panic. Rates will come back down eventually, and you can refinance when they do.
Unfortunately, if you have variable-rate loans or credit card debt, you are likely to see an increase in your borrowing costs.
2) You can earn more on savings
The rate that the Fed sets is closely tied to interest rates on savings products, such as certificates of deposits (CDs) and high yield savings accounts. That means that this is a great time to put your money into these vehicles. Do some research and see where you can grow your money with high interest rates.
3) It could be a good time to enter the stock market
To be clear, I don’t recommend trying to time the stock market. But stock markets can be negatively affected by higher interest rates as well.
On one hand, yes, that means the return on your stocks or equity-based investments will be lower. That stinks.
But this is also a good opportunity to enter the stock market at a lower price point.
If you want to learn how to overcome the roadblocks that stop a lot of women from entering the stock market AND how to implement our tried-and-true system for building wealth, then check out our free masterclass!
Final Thoughts
At the end of the day, rising interest rates aren’t inherently good or bad, but it is something you need to be aware of in order to make smart financial decisions. I hope that this helps you better understand the current economic climate as you decide how to best manage your money.
Like I said before, if you want to learn more about wealth-building, join our free investing masterclass. I hope to see you there!
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