The Fed and Your Funds: What Interest Rate Cuts Really Mean

Discussions about the Federal Reserve's (The Fed) interest rate decisions often dominate financial news. Whether the Fed is hiking rates to combat inflation or cutting them to stimulate the economy, these actions have a wide-ranging impact that can be confusing for the average investor.

As the central bank considers or implements an interest rate cut, it's important to understand the mechanics of what is happening and how it could influence different parts of your financial life.

The Two Key Interest Rates

When you hear about the Fed "cutting rates," they are primarily referring to the Federal Funds Rate.

1. The Federal Funds Rate: This is the target rate that commercial banks charge each other for overnight borrowing to maintain their required reserve balances.

2. The Discount Rate: This is the interest rate at which commercial banks can borrow money directly from the Federal Reserve.

When the Federal Open Market Committee (FOMC) decides to cut the target Federal Funds Rate, it makes it cheaper for banks to borrow money. This, in theory, encourages them to lend more money and lower the interest rates they charge consumers and businesses, which can boost economic activity.

How a Rate Cut Can Impact Your Finances

A Fed rate cut creates a ripple effect across the economy, affecting different financial areas in distinct ways:

The Potential Upsides

• Borrowing Costs: The most direct effect is on new debt. Rates for things like credit cards, personal loans, and home equity lines of credit (HELOCs) often follow the Fed's movement. If you're planning a major purchase or want to consolidate high-interest debt, lower rates can make borrowing cheaper.

• Mortgages: While not directly controlled by the Fed's short-term rate, long-term interest rates like those for 30-year fixed mortgages are generally tied to the bond market. However, a pattern of Fed cuts often correlates with lower mortgage rates, which can increase affordability for homebuyers and make refinancing a viable option for existing homeowners.

• Business Growth: Cheaper borrowing costs for businesses can stimulate investment, hiring, and expansion. This general boost in economic activity is often seen as favorable for the overall stock market.

The Potential Downsides

• Savings and Cash Yields: The lower-interest rate environment can negatively impact savers. The yields (Annual Percentage Yields, or APYs) on deposits in high-yield savings accounts, Certificates of Deposit (CDs), and Money Market Funds typically decline. If you have a large cash position, you may earn less interest.

• Fixed Income: For investors relying on bonds and other fixed-income securities for income, a decline in prevailing interest rates generally means that new bonds will offer lower yields. Furthermore, when rates fall, the value of existing bonds that pay a higher interest rate typically goes up. Conversely, if you hold existing bonds and rates continue to decline, your reinvestment risk (having to buy lower-yielding assets when your bonds mature) increases.

What This Means for Your Financial Strategy

Financial decisions should not be made based on anticipating the next Fed move. Attempting to time the market or economic cycles is exceptionally difficult and carries significant risk.

Instead, a shift in the interest rate environment is an ideal time to perform a strategic review:

1. Review Debt: If you have high-interest, non-deductible debt, lower rates could create an opportunity to refinance or consolidate.

2. Revisit Your Cash: If your emergency fund is earning a low rate, discuss with your financial professional whether its current location still aligns with your liquidity needs and your overall financial plan.

3. Stay Focused on the Long Term: A core tenet of long-term planning is maintaining a diversified portfolio that is aligned with your personal risk tolerance and time horizon, regardless of short-term economic shifts.

If you’re unsure how the current rate environment may affect your specific long-term plan, we are here to help you conduct a thorough review.

Important Disclosure:

This material is for informational purposes only and is not intended to be a substitute for specific, individualized tax, legal, or investment advice. The discussion of interest rate impacts is general in nature. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results. No strategy can assure success or protection against loss. Ramsey Financial does not provide legal or tax advice; please consult your own legal and tax professionals before taking any action. This communication is considered a "Retail Communication" and has been submitted to the firm’s supervisory principal for pre-approval prior to its public distribution.