What Does 'The Fed Raised Interest Rates' Even Mean?

Episode 40 July 28, 2023 00:16:31
What Does 'The Fed Raised Interest Rates' Even Mean?
New Money New Problems Podcast
What Does 'The Fed Raised Interest Rates' Even Mean?

Jul 28 2023 | 00:16:31

/

Hosted By

Brenton Harrison

Show Notes

The Fed just raised interest rates to their highest levels in over 20 years ...


But ... what does that even mean? 

View Full Transcript

Episode Transcript

Brenton: the Federal Reserve just raised interest rates to their highest levels in the past 22 years, and if you're like most people, you have absolutely no idea what that means. In this episode, we're gonna finally tell you what it means and five ways that the interest rate increase impacts your finances. Let's get started. Brenton: Hello, my name is Brenton Harrison of New Money, New Problems, and your host for the New Money, New [00:01:00] Problems podcast. If you've been following along with the news, even if not, just specific financial news, general news will let you know that this week, the Federal Reserve raised interest rates to their highest levels in over two decades. And to me, it's always interesting when I see the title of these articles because they've raised rates several times over the past few years because I don't think that most people know what that even means to say they raised rates. What is the rate? How does it impact me? So I wanted to do an episode and tell you what it means. And to do so, we have to get into some monetary theory that I think is simple enough to follow along and hopefully this helps. The Federal Reserve exists to control the supply of money in this country, so they're trying to, as best as they can, use the control of the money supply to make sure we have a predictable incremental path forward to success as opposed to big highs or big lows. Now you don't have to be following along with the news to know that our country is [00:02:00] in a period of extended inflation. Food costs are going through the roof. You probably remember when eggs last year somehow cost $11 for a dozen eggs. Home prices are exploding. The cost of used and new cars are going up. Salaries are going up really, really fast. So the Fed sees this as a danger sign and they're trying to use that supply to pull back the reins of inflation. And the way that they do that is by raising the interest rate. And that interest rate is called the federal funds rate. There are all different types of interest rates, but the federal funds rate is the rate that big banks charge each other to Loan money back and forth overnight. I know that sounds weird, but even banks take out loans, and many times when they take that Loan, it's from another financial institution. The average rate that banks charge each other for these overnight loans is called the federal funds rate. So when the Fed raises interest rates, that's to what they're referring. And what happens is when they raise that rate, they're essentially making it more costly for banks [00:03:00] to borrow money. And when it costs more for banks to borrow money, they pass on those increased costs to their consumer in the form of higher interest rates on mortgages or car loans and the like. It also has an impact on other types of interest rates. For example, a higher federal funds rate can lead to a higher prime rate, and the prime rate is an interest rate that greatly impacts what you pay for things like credit cards or home equity lines of credit. The federal funds rate can also impact the secured overnight financing rate, which is closely tied to what private student Loan lenders charge, which we'll talk about a little bit after the break. So it has a number of different impacts and the Fed is hoping that that stems the tide of inflation. 'cause if you pass on the cost to the banks and the banks, pass it on to the consumers instead of borrowing like they were before. Maybe people don't borrow as much for things like that car Loan or that home Loan, or maybe they choose not to borrow at all. Which means that if there aren't as many buyers in the market, some of those home prices might have to come down. If you increase the cost of [00:04:00] borrowing for a company, that company may not be able to expand as quickly as they wanted to. And as a result, maybe they can't hire as many people as they were going to before. Maybe they don't have as many salary increases as they did before, and all of those things collectively would hopefully drive down the price of things that you see in this economy. But in the interim, while we're waiting for that to occur, there are a number of things that can impact your money on a day-to-day basis. So after the break, we're gonna tell you five ways that these increased rates could have an effect on your wallet. [00:05:00] Brenton: Before the break, I mentioned that when you have lower Debt cost in terms of their interest rates as a business owner or a corporation, it could encourage you to grow. If you can borrow funds at 2%, you might have an extra incentive to hire a few employees or to take on a new product or venture that you wouldn't have if those [00:06:00] same interest rates were at five or 6%. So by increasing those interest rates, one of the things that you do is you impact that company or that corporation's ability to grow. And that's not just in terms of new Debt, it's even in servicing their old debts. If you have something that has a variable interest rate that's impacted by the federal funds rate, you can see that company not just not hire new employees, but even have to let go of current employees like we've seen in the tech space. Or you can be in a position where because they can't grow like they wanted to, their profits are lagging. And when you have lagging profits with a publicly held corporation, that typically impacts the stock price. And some of this has to do as much with public sentiment as actual reality. If I'm looking at a company that's in my portfolio and I feel that over the next year or six months, for whatever reason, they won't have as good of a profit as they had in years past, I might sell that stock. And if there's not a strong market of buyers who wanna buy it at the current price, then that price has to drop until those [00:07:00] buyers are satisfied. And when you have that happening at hundreds of companies across the economy, especially big companies, that's when you start to see the impact in things like the mutual funds inside of your 4 0 1 k that might hold those stock positions or an index fund like the S&P 500 that might be comprised of some of those companies. So the first area where you might see an impact of these interest rates is in the stock market. The second area is in the bond market. We've covered in the past that a bond is when you lend money to an institution or a city or even a country, and they use those funds to fund certain ventures, and you're lending it to them for a specific period of time at a set interest rate. But there are also bond marketplaces where you can sell those bonds because they have a monetary value. As an example, let's say that I have a five year corporate bond. That means I've taken, say, a thousand dollars and I've loaned it to a corporation for five years. If I keep the bond for the entirety of that time, and maybe it's giving me a [00:08:00] 5% interest rate, $50 for the year, and if I keep it for the entire five years, I'll get five years of $50 payments and then I'll get my a thousand dollars back at the end of the exchange. And even though I gave up a thousand dollars for that bond, what I can sell it for on the marketplace has a lot to do with how many interest payments I might have left. Why would somebody buy that bond for a thousand dollars if there's only one year's worth of payments left? It also has a lot to do with what other interest rates are available for bonds in that marketplace. As an example, I got my bond, let's call it four years ago, and it was for a thousand dollars. And I'm getting 5% a year on my a thousand dollars, but since that time, the Fed has raised interest rates and that raises rates for new bonds as well. So whereas I got my bond for a thousand dollars at 5% interest, there are new bonds that are flooding the marketplace every single day where someone can give that corporation a thousand dollars and they can get 7% interest on that investment. [00:09:00] And that new bond at 7% interest is sitting there in the same marketplace as my bond at 5% interest with only one year's payment left. And we're both trying to get someone to buy our respective bond. Well, the one that's newer, And has a higher interest rate is going to be worth more than the older bond at a lower interest rate. So instead of charging a thousand dollars for it, I'm going to have to drop my price below a thousand dollars until it reaches the point where it becomes attractive. This is what it means when people say that when interest rates go up, bond prices go down. It's not the price of new bonds. It means that for previously existing bonds that are in the marketplace at lower interest rates, people who are selling them have to decrease the cost to make it more attractive. If you have bonds that you own directly, or if you have previously existing bonds in your portfolio, in mutual funds and things of that nature, you can see those prices drop as well, which can have an impact on the returns in this portion of your [00:10:00] account. It also means that moving forward until that investment manager, whomever you're using to pick your investments, has an idea on what interest rates will be in the long term, they may be hesitant to sign up for bonds that have a long window. They don't wanna sign up for a 10 year bond or a five year bond, because what if interest rates rise again and they're left holding the bag? So instead, they might choose to only invest in bonds that are called short-term bonds until interest rates level out so they're not left in a situation where they have a bond that's not competitive in the marketplace should they choose to sell. The third place, you'll see the impact of rising interest rates is exactly where you'd expect it: debts. When you have things like mortgages, when you have things like car loans, when you have things like credit cards, it's going to be more expensive to borrow those things in a period of increased interest rates. Now, if you're looking for a new mortgage, obviously you would know that every single time they've raised the rates, the rates on mortgages have gone up as well. Now if you already [00:11:00] have a mortgage, you're already in your home, and you were thinking about maybe selling that home and buying another one, well, there are two factors that are at play. The first is because it now costs more for potential buyers to get your home, it may depress the price that you're able to sell it for, but even if not, and you're able to sell it for a mint, you have to consider the fact that now you have to go find another home, and the mortgage on that home may be double or triple what it was at your old house, which means that it costs significantly more. And when that happens, you're much more likely to just stay put. So that's for something that's a fixed rate. You know what it is, it's not going to change throughout the course of your Repayment, and you can decide whether you want to sign up for it or not. And when you sign up for it, you know exactly the rate for which you've signed up. But there are also variable debts where when interest rates are low, it may be an attractive option to borrow from, but as interest rates increase, the rates on those loans, increase with them. These are things like home equity lines of credit, which many people might use to finance. Things like [00:12:00] home repairs or renovations. It's things like credit cards where when interest rates were low, Maybe it wasn't that big of a deal to you to keep five or $6,000 on a credit card without actually making an effort to pay it down. But when interest rates increase, the rates on these debts rise with them, and your servicing costs for that Debt can get sky high. So during this period of time, you really want to avoid having unnecessary balances on any variable debts. And if you can, you want to work as hard as you can to pay down any existing balances to zero as fast as possible. The fourth area is one we've been talking about a lot recently, and that has to do with student loans. Now, federal student loans, their interest rates are set very irregularly. It's not something that changes on a monthly basis, so you don't see a huge impact on the rates you pay for federal student loans in terms of rising federal funds rates. But you do see a real impact when it comes to the rate that are charged by private student [00:13:00] Loan lenders. As student Loan payments are about to restart there's a lot of people who are wondering, should I still keep my loans with the federal government or should I try to refinance them with a private lender? On my other podcast, Escape Student Loan Debt, which I have to say is not affiliated with New Money,, New Problems in any way, we're gonna be talking about that, uh, over the next several weeks. But what I would say is this: private student Loan rates are often set based off of the secured overnight financing rate that we referenced in the first part of this episode. That rate is a variable rate, and it changes frequently. So when that rate goes up, which it does when the federal funds rate goes up, the rate that you see on private loans rises with it. And when it comes to refinancing a federal student Loan with a private lender, one of the main reasons that you would do it is if you're experiencing an interest rate savings by moving to that private lender. And the odds of that happening are reduced during periods of rising interest rates. So I would say that until these interest rates [00:14:00] decrease, it's unlikely that a federal student Loan borrower would experience a savings by taking that federal Loan and refinancing it with a private lender. But because those private rates can change frequently, if and when interest rates go back down, that's when you start to evaluate whether it makes sense to pull the trigger on a student Loan refinance. And then finally I figure we end with the positive. When you see an increase in the federal funds rate, you also often see banks increase the interest rates that they're crediting to their savings account customers, to their high yield savings account customers, to their money market account customers, if it's an investment company. And these can make it very attractive to increase the amount of reserves that you have in your accounts and to pay down your debts that might be subject to those interest rate increases. So we're coming out of a period where stocks were going gangbusters for several years. Credit card interest rates were low. It cost nothing to get a home loan. Uh, the amount that you were getting credited on your savings rate was next to nothing.[00:15:00] And in that period of time it didn't make much sense to keep a sky high emergency reserve. But now we're seeing credit unions and online banks and money market accounts that are offering 4.5%, 5%. We're seeing CDs that are offering 5% and 6%, and for the first time, I would say in over a decade, there is a lot of merit in keeping a good amount of cash on hand, even in some cases above and beyond the emergency reserve that we've talked about ad nauseum on this podcast. So if there is a silver lining to periods like this, it's when you look at things like those savings accounts where you know exactly the rate that you're gonna get, it's pretty high. And in some cases it could even be more appealing than putting those funds into what is a volatile market where you don't know what the return will be, or even if that return will be positive at all. So I have two hopes for this episode. The first is, I hope that this gave you clarity and an understanding of what it means when people are saying, oh my goodness, the Fed raised interest rates again. But my second hope is that it gave you an idea of where you can look in your [00:16:00] finances to understand the impact that these interest rates has on your day-to-day life. I'll be back with another episode next week, and I can't wait to see you guys then talk to you soon.

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