The Far-Reaching Influence of the Federal Reserve

When discussing the financial markets, a central theme often emerges: the role of the Federal Reserve, known as the Fed, and the interest rates it influences. As the U.S. central bank responsible for conducting the nation’s monetary policy, the Fed has a “dual mandate” to foster maximum employment and price stability, including seeking to keep inflation in check. It does this primarily by influencing key interest rates.

How the Fed influences interest rates

The Fed directly controls the federal funds rate, or ‘fed funds rate’ — the rate at which depository institutions, such as banks and credit unions, lend reserve balances to one another overnight. This benchmark interest rate is set by the Federal Open Market Committee (FOMC), the monetary policy-making arm of the Fed, during their meetings, which typically occur eight times a year.

The fed funds rate is critical because it influences virtually all other interest rates in the U.S., from the interest you earn in a savings account to the rate you pay on a mortgage.

Generally, the Fed:

• Lowers interest rates to help stimulate economic growth, which can boost job creation and consumer spending. These adjustments are a delicate balance, aimed at stabilizing the broader economy.
• Raises its policy rate to help curb inflation when it begins to rise beyond a target threshold, currently set around 2%. Higher interest rates make borrowing more expensive, which can slow economic growth and help keep inflation in check.

Impact on saving

The interest rate environment has a direct impact on the returns from interest-bearing savings accounts and certificates of deposits (CDs), which generally compound over time.

• When the Fed lowers interest rates, savers might see a decrease in the interest earnings from their bank deposits. If you expect rates to go down, this doesn’t mean you should stop saving. Seek competitive rates and consider diversifying into higher-yield savings products to enhance returns. CDs could be a good savings option as you may be able to lock in a rate before the Fed decision.
• Conversely, when interest rates rise, the yields on savings accounts and CDs typically increase, providing better returns on saved money. Options like high-yield savings accounts, which offer higher interest rates than standard accounts, and interest-bearing checking accounts, can help enhance savings.

Saving needs to be strategic in any changing interest rate environment. Understanding savings strategies and how they relate to Fed interest rate changes can significantly enhance a saver's ability to meet short-term savings objectives.

Impact on borrowing

Mortgage and credit card rates are particularly sensitive to changes in the Fed's interest rate policies. These rates are typically tied to the “prime rate,” or the rate that banks offer their most creditworthy customers, which, in turn, is influenced by the fed funds rate.

When the Fed cuts rates, mortgage and credit card interest rates generally decrease, making borrowing more attractive.

• Potential homebuyers can prepare by getting pre-approved so that they’re ready to take advantage should rates fall, and homeowners can consider refinancing. In addition, keep an eye on the 10-year Treasury note, a key benchmark for most mortgage rates as they tend to move in the same direction.
• For credit card holders, you might choose to apply the money you’re saving on interest toward paying more towards any outstanding balances.

When the Fed raises rates, mortgage and credit card interest rates increase, making it more expensive to borrow and to leave unpaid balances on credit card accounts.

Impact on investing

The relationship between interest rates and the markets is complex, making it challenging to predict market direction with certainty. Generally, however, investors can better position their portfolios to respond to changes in interest rates by understanding the following implications:

Lower interest rates can make borrowing cheaper, potentially driving business expansions and consumer spending, which often benefits stocks.

Because bond yields and prices move in opposite directions, falling interest rates could also boost the value of bonds in a portfolio. Keep in mind that lower rates may mean lower returns on short-term fixed income options like money market funds. Investors may want to consider reallocating money to long-term fixed income assets to lock in attractive yields at relatively lower risk before rates fall.

On the other hand, higher interest rates generally lead to higher borrowing costs, which can dampen company profits and consumer spending, potentially sending stock prices down. Rising interest rates can also lower the value of bonds in a portfolio.

Working with your Morgan Stanley Financial Advisor

For investors, including those who are planning for retirement, your investments may see many ups and downs over your lifespan. Consider staying invested and keep your long-term goals in mind and your emotions at bay. Maintaining a diverse portfolio can help you offset effects of any market changes.

Your Morgan Stanley Financial Advisor can help you stay informed on how Fed interest changes may impact your portfolio and adjust where needed to help you achieve your long-term financial goals.