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The US Federal Reserve (Fed), the most well-known and influential central bank in the world, is on the cusp of reducing the Fed funds rate, which can profoundly impact the US economy, job opportunities and, consequently, one’s finances.
The Fed funds target interest rate – currently between 5.25% and 5.50%, a 23-year high – is an upper and lower band set by the Federal Open Market Committee (FOMC), a division within the Fed that regulates the direction of monetary policy. Between early 2022 and mid-2023, the FOMC increased the Fed funds rate 11 times as the Fed attempted to control elevated inflation. Since then, the Fed funds rate has remained in restrictive territory at 5.25%-5.50%. According to the latest Consumer Price Index (CPI) report, inflation eased slightly more than expected in the twelve months to July to +2.9% (from +3.0% in June); this is down from a top of 9.1% in June 2022.
The Fed has a dual mandate to maintain inflation and support maximum employment.
Among other tools in its arsenal, the FOMC can control the supply of money in the US economy by adjusting the Fed funds target rate. This benchmark interest rate directly influences the rates at which commercial banks lend their excess reserves to one another in the overnight market and, by extension, the rates at which they lend to their customers.
With inflation heading in the right direction – towards the Fed’s 2% inflation target – the Fed will likely reduce the Fed funds rate at its next meeting on 18 September. This is an important event as the reduction of this interest rate influences a wide array of rates across the economy and essentially makes borrowing cheaper.
According to the CME Group’s FedWatch tool, which uses the prices of 30-Day Fed funds futures, a 75% probability of a rate reduction has been assigned to September’s meeting for a 25 basis point rate cut, with a 25% chance that the Fed cuts rates by 50 basis points as the recent softness seen in labour data could prompt the Fed to be more aggressive in easing policy. Investors also forecast a full percentage point decline in the Fed funds rate or 100 basis points for the entire year.
When the Fed reduces interest rates, it aims to increase the money supply in the US economy and lower the cost of credit to encourage economic activity. On the other hand, raising rates has the opposite effect, making the cost of credit more expensive, which usually slows down economic growth.
Benefits of an interest rate cut:
The most direct benefit of a rate cut is reduced borrowing costs. If you have an adjustable rate on your home mortgage or loans, these will likely be impacted if the Fed cuts rates in September. This is good news for borrowers as it will lower monthly outgoings.
A rate cut will likely lower your monthly mortgage payments, meaning thousands of dollars in savings over a 20 or 30-year mortgage if the Fed lowers interest rates by a full percentage point this year, as forecast. Lower mortgage rates will also increase housing affordability, increasing competition among buyers. Further to this, suppose you have a fixed-rate mortgage; while the Fed reducing its Fed funds rate will have limited immediate effect on fixed-rate mortgage holders, when the time comes to refinance, a lower rate will mean cheaper monthly payments and saving money in the long run.
Regarding credit cards, your credit card's Annual Percentage Rate (APR) may be reduced on the back of a rate reduction. Auto loans will likely be cheaper, increasing the affordability of purchasing new cars. A rate reduction would also impact student loans.
Drawbacks of an interest rate cut:
Conversely, the Fed reducing its Fed funds rate means lenders will receive a lower rate of return on their money. This can affect your return on checking and savings accounts, such as high-yield savings accounts and bonds.
The high likelihood of a rate cut may prompt investors to lock in current rates. For instance, retirees might consider short-term Certificate of Deposits (CDs) of a year or two, which pay about 5% and are comfortably above inflation, as the rates of these types of products will be reduced as the Fed funds rate is lowered (note that many providers can also reduce their rates in anticipation of a rate cut).
The Fed cutting its interest rate can present both challenges and opportunities for borrowers and lenders.
Understanding the potential impacts of a change in the Fed funds rate and taking proactive steps can position yourself to weather an economic change. Remember, it's essential to consider your financial situation and consult with a financial advisor if needed.
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