The US Federal Reserve cut the key interest rate by 50 basis points to 1.58% on March 2, 2020. This emergency move surprised many as it came before a scheduled Fed board meeting in March when rates are usually addressed. It also happened well before the ramifications of the Coronavirus were understood. However, the fed rate cut was administered to quell uncertain markets during an impending pandemic coupled with a crashing Dow. In this article, we review how the Fed rate affects financial markets and most importantly, how it affects the consumer.
What is the Fed funds rate?
The Fed Funds Rate is the benchmark interest rate that banks use to loan each other their excess reserves. On a high level, it is an economic tool used by the US central bank to control growth and inflation.
When the rate is reduced, the idea is to encourage lending, business investments, hiring, and ultimately, consumer spending. So with the recent .5% rate cut, the Fed hopes to stimulate the economy by making lending less expensive.
As one of the tools of a trickle-down economy, a Fed rate cut helps to jumpstart US markets by lowering other key rates and encouraging more borrowing and spending.
How does the Fed rate cut affect other financial products?
Most other rates in the American financial system are correlated with the Fed rate, which may also be referred to as the “Nominal Rate” or the “Federal Funds Rate.” When the Fed rate is cut, we may see any of the following effects:
- Credit card rates might fall slightly.
- Home equity lines of credit and car loans may also see a rate decrease.
- CD’s and savings rates go lower, disincentivizing savings and encouraging spending.
- US bank mortgage rates, which are not as directly correlated to the Fed rate, may also move in reaction to a cut. But usually, it takes longer to take effect and the decrease may be negligible. However, in this case, mortgage rates were already down one day after the Fed cut. Currently, mortgage rates are already at an all-time low.
How world markets are connected
When the Fed rate is hiked to a higher percentage, bank to bank lending will usually see higher yields, which in turn attracts investment capital. This may also draw capital away from other smaller economic regions. So when a cut to the rate is made, the opposite scenario may unfold, with more capital infused to other world regions instead of being invested in the US.
What does this mean for the average person?
Consumers are at the bottom of the trickle-down economy. But they’re also a required element in boosting markets through borrowing and spending. They are affected in multiple ways when the rate is cut:
- Borrowing gets a little easier on the wallet, as most credit rates are correlated to the Fed rate.
- The US dollar gets devalued. After a rate cut, investors tend to sell dollar-denominated assets to buy foreign assets, thus weakening the USD exchange rate.
- Savings are devalued with a rate cut, meaning the interest rates go down. So instead of encouraging Americans to save, the cut encourages spending and borrowing. Locked in Certificates of Deposit (CDs) should keep their rate, however. until maturity.
- If you have any money (or a pension) in the stock market, a rate cut is designed to inflate the value of stocks by encouraging stock buying. The hoped long term effect of a cut is to increase stock values and return the mode of stock growth.
How low can they go?
A particular concern to consumers is the overall health of the economy. The rate is now at 1.58%. There are not many cuts left that can happen with such a low rate already in place. However, the fed may soon cut rates again at the March meeting, and possibly in April as well.
But what happens when we can no longer cut the rate, or it becomes a negative rate? We’re now at this junction where we’ll likely see how low it can go, with the POTUS demanding negative rates to keep the growth outlook for stocks during his election campaign.
This unexpected rate cut came at a very turbulent time. The Coronavirus is sweeping across the globe. It is shutting down businesses as people stay home, virtually crippling the travel industry and sending oil and gas stocks in a tailspin. Some may say the move by the Fed came too soon, that it was influenced by pressure from the White House. But the Fed board argues it is not affected by politics and plans to adjust rates upon assessment of the effects of this global pandemic.