Nearing Retirement

The Fed, Interest Rates, and Investing

As an investor, you undoubtedly ask when, or if, the Federal Reserve Bank (the Fed) raises interest rates, how will that affect consumers and businesses? What about the consequences for certain segments of the economy?

Reason for the Fed’s Change
The most important tool available to the Fed is its ability to set the federal funds rate, or the prime interest rate. This is the interest paid by banks to borrow money from the Federal Reserve Bank.

Interest is, basically, the cost to the banks of borrowing someone else’s money. The banks will pass on this cost to their own borrowers.

To boost the economy, remember that the Fed set its benchmark interest rate close to zero in late 2008 and did the same thing at the beginning of the COVID pandemic. This resulted in “free money.”

By reducing the federal funds rate, the Fed increased the supply of money by making it less expensive to obtain. As a result, businesses could have greater access to money. They could spend more on building their businesses and on hiring more employees. Because consumers and businesses had more money, they could purchase more goods, services, houses, and stocks.

Increasing the federal funds rate, on the other hand, reduces the supply of money by making it more expensive to obtain. Reducing the amount of money in circulation, by decreasing consumer and business spending, helps to reduce inflation. However, the Federal Reserve has to decide whether the increase in consumer demand and in hiring has led to enough inflation in prices to warrant a reduction in rates.

Consequences for Consumers and Businesses
Any increased expense for the banks to borrow money has a ripple effect, which influences both individuals and businesses in their costs and plans.

These broad interactions can play out in numerous ways.

Obviously, many factors affect activity in various parts of the economy. A change in interest rates, although important, is just one of those factors. Yet it is still important to prepare for any effects on your business, your livelihood, and your investment portfolio when an increase in the federal funds rate does take place.

Be sure to talk to your financial advisor for specific guidance.