By Jane Young
Short term interest rates are controlled by the Federal Reserve Board which operates under a congressional mandate to maintain economic stability by maximizing employment and managing inflation. The primary mechanism used to influence economic stability is the federal funds rate. The federal funds rate is the interest rate that banks charge each other for overnight loans to meet reserve requirements. The prime rate, the rate that banks charge their most creditworthy clients, is determined by individual banks but is heavily influenced by the federal funds rate.
A change in the prime rate directly impacts short term and variable interest rates throughout the economy. The prime rate impacts rates on credit cards, personal loans, auto loans, private student loans, adjustable rate mortgages and home equity loans. It also has a direct impact on interest earned on bank accounts and Certificates of Deposit.
The 30-year fixed mortgage rate is not directly impacted by the prime rate, it is influenced by the 10-year Treasury note. The 10-year Treasury note is sold at auction and is subject to market forces and consumer sentiment. The factors that impact the rate on the 10-year Treasury note include supply, demand, monetary policy, inflation, and economic conditions. Monetary policy comprises the Federal Reserve’s actions to promote maximum employment and stable prices.
Over the last six months, interest rates have fallen dramatically in response to the COVID-19 crisis. During their September meeting, the Federal Reserve Board signaled an intention to keep interest rates close to zero through 2023.
The Federal Reserve cuts the federal funds rate to reduce the price of money to encourage borrowing and discourage saving. Their goal is to get more money into the economy rather than sitting in the bank. Thus, businesses can borrow at lower interest rates which enables them to grow. They will also spend less on debt in general. This leads to more hiring and reduced unemployment. Consumers are also more likely to spend in a low interest environment. They will have greater incentive to take out a personal, auto or home equity loan at lower interest rates. They are also more likely to spend rather than keep their money in a low interest savings account.
Low interest rates are generally beneficial for the stock market. Greater consumer spending and the ability to borrow at lower rates leads to improved corporate profits which translates to higher stock prices. Stocks also get a boost from investors willing to take on additional risk in stocks due to limited returns on fixed income investments.
Although returns on the stock market seem more appealing in a low interest rate environment it is essential to maintain a balanced portfolio of stocks and fixed income investments to buffer against fluctuations in the stock market. Be sure to maintain an emergency cushion and keep adequate funds outside of the stock market to cover spending needs for at least five years.