On Wednesday, August 31, 2019, the Federal Open Market Committee (FOMC) announced a 0.25% cut in the prime interest rate. That doesn’t sound like a whole lot, but it’s notable because it’s the first time rates have been cut since 2008. But what does it mean for Wall Street — and Main Street?
In the short term, the market tanked. While many pundits believed that the rate cut was already “baked in” to the market— in other words, it was expected, and the market had already priced for it— the Dow Jones Industrial Average lost 330 points after the cut was announced. But the consensus is that the reason for the drop was not the cut itself, but rather the fact that Fed Chairman Powell hinted that this would be a one-off, and further cuts were not assured. But what does this mean for you as an individual and an entrepreneur?
What to Know About Interest Rates
The interest rate that the Federal Reserve Bank controls is the federal funds rate. The federal funds rate is the rate that banks charge one another for overnight loans. The Federal Reserve Board sets a target rate for these loans, but it cannot force banks to charge this rate. So when you hear that ‘the Fed’ cut or raised ‘the interest rate,’ it’s the Fed funds rate they’re referring to.
The fed funds rate is not the same thing as the prime interest rate, but the two rates typically move in the same direction. So, a decrease in the fed funds rate usually precipitates a decrease in the prime rate and vice versa. The prime rate is the interest rate determined by banks. Again, the Federal Reserve Board cannot dictate this rate, but their actions often influence it.
The FOMC consists of the seven members of the Federal Reserve Board of Governors and five of the 12 Federal Reserve Bank presidents. It is the Federal Reserve System’s monetary policymaking body.
How the Rate Change Could Affect You
Money will be cheaper. When interest rates fall, banks charge less when their customers borrow money. Whether it’s a small business loan, a mortgage or a student loan, a lower fed funds rate often leads to lower rates on loans.
Credit card rates may fall. Many credit card interest rates are tied to the prime rate and will change when the prime rate changes. If you check your credit card statement, you may see that your rate is variable, and expressed as a number added to prime, such as “Prime + 14.99%.” In this case, the interest rate you will be charged on your credit card balance will be 16.99% if the prime rate is 2%, but 17.99% if the prime rate is 3%.
Business expansion could bump up inflation. As businesses borrow more money to expand, they may charge more for their products to cover the added costs. They could also pay their workers more as labor becomes more scarce. Higher wages and higher prices lead to inflation, which can be moderated by increasing the interest rate.
What Happens Next?
The Fed funds rate will continue to fluctuate, as the Federal Reserve Board attempts to stimulate business while curbing inflation. If business slows down, the rate may be decreased in order to stimulate spending. This is what happened from 2008 until recently, as the interest rate was cut to try to jump-start the economy after the Great Recession.
If business is doing well and entrepreneurs borrow money to expand their businesses, prices may begin to creep up. If prices rise to the point of inflation, the Federal Reserve Board may cut rates in order to stem inflation by keeping borrowing and expansion in check.
It’s All Relative
After the recent rate cut, the target range for the Fed funds rate is 2 – 2.25%. Historically, this is very low. The average rate from 1971 to 2019 was 5.66%, and the highest rate ever was 20% in March 1980. At this point in time, it was not unusual to see home mortgage with interest rates of 18 – 20%. This sounds horrifying to those with 3% mortgages today, but the effect was to depress home prices so that people could still afford their mortgages. Once the rate started to decline, the refinancing boom was born as homeowners fled their high-rate loans.
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The Future Outlook for Rates
If the Federal Reserve Board decides it needs to continue to stimulate the economy, it will cut rates further. If it feels that the economy is growing at a reasonable pace without being inflationary, rates will stay where they are. If inflation kicks in, rates could be raised in order to curb it. For consumers and business owners, the real impact of an interest rate swing of a quarter to a half point is minimal, but repeated changes in the same direction or larger moves may change the economic outlook.
The FOMC meets eight times per year to decide whether to adjust the interest rate, so we won’t have to wait long to find out what happens next.
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