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The Federal Reserve and Interest Rates

How They Are Determined and How They Affect Your Portfolio

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The Federal Reserve is responsible for maintaining full employment (generally considered to be around 4 to 5 percent unemployment) while keeping inflation low. This task may sound simple but, in reality, it's a delicate balancing act.

The most powerful weapon in the Fed's arsenal is the ability to influence the direction of interest rates. When interest rates are low, capital is easier to acquire. This can spur economic development because, human nature being what it is, the more cash you have available, the more you are likely to pay for something you want - whether it is a car or that new plasma screen television. Left unchecked, however, and the result is "too much money chasing too few goods," as the saying goes. This leads to inflation as businesses realize they can charge higher prices for their goods and services. Suddenly, it costs you more to fill up your gas tank and refrigerator.

If interest rates are too high, however, the result can be a recession and, in extreme cases, deflation; the result of which can be economically devastating - imagine going to pay off your mortgage and realizing that, although the balance has not increased, it's going to cost you more dollars in terms of purchasing power than it did before!

How can the Federal Reserve influence the direction of interest rates? In one of two ways:

  1. By raising or lowering the discount rate.
  2. By indirectly influencing the direction of the Federal funds rate.

The Discount Rate

The discount rate is the interest rate banks are charged when they borrows funds overnight directly from one of the Federal Reserve Banks. When the cost of money increases for your bank, they are going to charge you more as a result. This makes capital more expensive and results in less borrowing. Spending decreases, causing it to become more difficult for prices to rise; the opposite being true when capital becomes less expensive due to a decrease in the discount rate.

The Federal Funds Rate

The Federal funds rate is the rate that banks charge each other for overnight loans. "Why would one bank borrow cash from another?" you ask. The Fed can require banks to keep a certain percentage of assets in the form of cash on hand or deposited in one of the Federal Reserve banks. From time to time, it will establish a required ratio of reserves to deposits; when this ratio is increased, more cash must be kept in the vault at night, making it more difficult (and expensive) for funds to be acquired. When the reserve requirement is lowered, the money supply is loosened; because less cash has to be kept on hand it becomes easier to acquire capital.

The increased (or decreased) cost of acquiring funds is passed on to consumers as banks adjust their prime lending rate (the rate banks charge their best customers) to compensate. The prime lending rate is not uniform; Bank of America may have one rate while U.S. Bank has another. As a result, the most widely quoted prime rate figure in the United States is the one found in the Wall Street Journal. It represents a polling of the nation's thirty largest banks; when twenty-three of those institutions have changed their prime rates, the WSJ responds by updating the published rate. This ultimately affects your bottom line because many credit cards, for example, base the interest rate you pay on a premium above the WSJ prime rate.

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