Untangling the Influence of the Fed Funds Rate on Your Finances
May 30, 2024
Earlier this month, the Federal Open Market Committee (FOMC), the policymaking body of the Federal Reserve, announced the target fed funds rate will continue to hold steady at 5.25-5.50%. As media speculation and investor hopes of rate cuts continue to get pushed back into late 2024, the market is currently only pricing in one or two quarter-point rate cuts this year.
While the federal funds rate often dominates financial headlines, there are many misconceptions about the direct impact of this well-known rate. The influence of the fed funds rate on your day-to-day finances might not be as straightforward as it seems. Let's unravel what exactly this rate is and isn’t.
- Fed Funds Rate Explained: The FOMC, sets the target fed funds rate, which dictates the interest rate at which banks lend to each other overnight. It serves as a key tool for the Federal Reserve in implementing monetary policy, influencing borrowing and spending in the economy.
- How the Fed Funds Rate Works: When the rate increases, in general, it becomes more expensive to borrow. And because it’s an overnight lending rate it also greatly impacts short term interest rates. Although it influences a wide range of interest rate measures, it’s direct impact on the interest rates we regularly encounter remains somewhat ambiguous. Mortgage rates, auto loan rates, and treasury note yields are just a few examples.
Many of the interest rates that impact our lives more closely are influenced by longer term rates, such as the 10 Year Treasury, rather than the fed funds rate. So if the FOMC adjusts the fed funds rate, it might not trigger an immediate or exact response in mortgage rates, which could certainly sway your homebuying or refinancing decisions. The same is true for automobile loans, which are often influenced by broader economic trends and supply and demand in the auto industry.
As you can see in the chart below, the 10 Year Treasury Rate and 30 Year Mortgage Rate often anticipate a move in Fed Funds and make their move in advance of the FOMC announcing a change in the fed funds rate.
Other times, as seen in late 2023 and early 2024, there can be substantial moves in other rates while the fed funds rate remains flat.
So, while a fed funds rate cut might lead to a lower interest rate on a car loan or mortgage, it's not an immediate and direct cause-and-effect.
Why the Disconnect?
- Time Horizon Discrepancy: The federal funds rate more directly impacts short-term borrowing costs, whereas Treasury yields, mortgage rates, and auto loans have a greater influence from long-term expectations.
- Market Expectations: Treasury bonds, auto loans, and mortgage rates are driven by a wide range of factors beyond just the Fed’s actions: investor expectations for future economic conditions, inflation, and supply and demand to name a few.
- Risk Premiums and Spreads: Mortgage rates incorporate additional factors such as credit risk, prepayment risk, and liquidity risk, which are not directly influenced by the fed funds rate. Lenders must account for these risks when setting mortgage rates, leading to differences between Treasury yields and mortgage rates.
While the Federal Reserve's monetary policy decisions play a crucial role in shaping overall financial conditions, the direct impact of the fed funds rate on Treasury yields, mortgage rates, auto loans, as well as other rates that commonly impact our lives is often less pronounced than commonly perceived.
It's important to remember that the fed funds rate only directly controls the target rate at which banks lend to each other overnight. While the federal funds rate may get more focus from the media, it's the movements in longer-term rates that have a greater impact on your personal finances.
At VeraBank Wealth Management we understand these rates are constantly evolving, and that’s why our team is here to help you reach your financial goals.
To learn about VeraBank Wealth Management services and how we can support your wealth management needs, connect with our team, or explore our services.
Disclosure
This document serves as a general communication intended solely for informational purposes. It aims to provide educational content and does not constitute a recommendation for any specific investment product, strategy, or plan feature. The examples provided are generic and hypothetical, used for illustrative purposes only. Before making any investment or financial decisions, it is advisable to seek personalized advice from your own financial, legal, tax, and other professional advisors, taking into consideration your individual circumstances. Past performance and outlooks do not guarantee future results.
Additionally, please note that securities provided by VeraBank Wealth Management are not deposits of VeraBank, are not FDIC insured, have no financial institution guarantee, and may lose value.