May 27, 2020

How the Fed Rate Works

The Federal Reserve has been in the news lately because it lowered the benchmark interest rate to 0%. This move is intended to keep credit markets going, which can be good news for small business owners.

“Although the federal funds rate, which is what banks charge one another for short-term borrowing, is not the rate that consumers pay, the Fed’s moves still affect the borrowing and saving rates they see every day,” explains a financial report from CNBC. “For example, credit card rates are down to a 3-year low of 16.46% from a high of 17.85% when the Fed started cutting rates last July.”

All of these moves are part of the Fed’s efforts to rescue our economy from the negative impacts brought on by the COVID-19 crisis. If the rates are lower, financing should be more available and affordable. Businesses will start and grow bigger. Lower credit card rates will hopefully help consumers feel confident about making more purchases at more of these stores. Homeowners with adjustable-rate loans will have more money each month to put back into their local economies.

It’s all part of a beautiful cycle that helps us get back on track sooner, which is crucial because research shows that 32% of consumers are expecting income decreases within the next 14 days. Tied to this reduction in pay is an understandable hesitance to make the kinds of purchases they normally would.

But how does the Fed rate actually work? It all starts with the fed funds rate, which has been referred to as “the most powerful interest rate in the world.” This rate serves as a benchmark for interest rates across the board. So your mortgage, car loan, or credit card would likely be impacted by changes to the fed funds rate.

“One of the most significant rates influenced by the fed funds rate is the prime rate—the prevailing rate banks charge their best customers,” says The Balance Small Business. “The prime rate affects many consumer interest rates, including rates on deposits, bank loans, credit cards, and adjustable-rate mortgages.”

This is all relevant because the fed funds rate has been lowered multiple times in recent weeks. These types of changes aren’t intended to yield immediate results. It’s a long game, and it’s more likely that the national economy would show reactions a year or more down the road.

Lower rates can be great for consumers, but the Fed will probably raise the rates soon. Borrowers, homeowners, and credit card users will all feel the pinch of higher rates.

Why would the Fed do this? Because extended periods with exceptionally low rates bring issues of their own. The government is more likely to increase the national deficit, lenders begin approving high-risk borrowers, and it eliminates the Fed’s ability to lower the rate again if there were another crisis.

The Fed takes no joy in raising rates, but it’s part of a delicate economic balance for our nation. What’s important is that you understand how to capitalize on the current situation to give your small business the best chance for success.

About the author

Grant Olsen
Grant Olsen
Grant Olsen is a writer specializing in small business loans, leadership skills, and growth strategies. He is a contributing writer for KSL 5 TV, where his articles have generated more than 6 million page views, and has been featured on FitSmallBusiness.com and ModernHealthcare.com. Grant is also the author of the book "Rhino Trouble." He has a B.A. in English from Brigham Young University.

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