Keeping it Interest-ing!
The last interest rate hike of a whopping .075% brought us to 3% above where we were in 2019—which was 0% (good times!). So if high interest rates are such a bummer (to say it lightly!), then why does the federal reserve keep jacking them up?—And what should you do to position yourself to come out ahead?
Jump Ahead to
First let’s start with the basics: when someone on the news is talking about “interest rates” what they really mean is the target federal funds rate, aka the fed funds rate, aka short-term interest rates.
The target federal funds rate is the guideline decided by the Federal Reserve that banks should charge each other when loaning money back and forth. Why would banks need to loan money to each other? Well, banks that accept deposits from their customers are required by law to keep a certain amount of cash on hand, so people can withdrawal their money. This required amount is based on a percentage of the total deposited money that their customers have in that bank, and it is called the reserve requirement. So, at the end of the day, some banks might fall short of their reserve requirement and others will have access. Thus, the lending back and forth.
Notice we referred to the federal funds rate as a guiding range—The Fed cannot dictate what interest rates banks charge each other. That’s up to them to negotiate. The actual interest rates that banks end up charging each other is called the effective federal funds rate. But the Fed can influence this rate.
Eight times a year, the Federal Open Market Committee (FOMC), a group of important people from the Fed in charge of making sure our economy is healthy, have a powwow to determine the ideal federal funds interest rate. In order to actually get banks to charge each other this rate, the FOMC either adds money into the financial system, which increases supply and lowers the effective rate, or they take money out of the system, which decreases supply and increases the effective rate (the old supply and demand!). So yeah it’s a “guideline,” but the Fed is pulling strings behind the scenes to make it happen!
Why increase interest rates?
So, why take all this time and energy to raise and lower interest rates, when we could all just borrow money for free forever? Raising interest rates is a tool that the Fed uses to combat inflation—inflation being the increase of prices for everything. Whether it be your groceries, gas, clothes, home goods or even the price for a glass of wine at your favorite restaurant—everything. Right now, as of October 2022, we are looking at the largest increase in over 40 years—8.3% according to the U.S. Bureau of Labor Statistics. That means on average you are paying 8.3% more for your stuff (both necessary and self-indulgent) than you did one year prior. Something must be done to get it under control—and that’s where higher interest rates come in.
How do interest rates lower inflation?
So, how do higher interest rates lower prices? The fed funds rate has a ripple effect on all other interest rates, whether it be mortgages, car loans and even your variable credit card APR. The point is for consumers (that’s us!) to be encouraged to buy less crap (because the “cost” of money is greater), so that the supply of consumer goods is greater than the consumer demand, therefore, forcing prices to lower or to at least stabilize—which would be great!—But higher interest rates can take 2 years to actually have this effect.
In fact, even as wholesale prices have gone back to normal, as the supply chain has mended its wounds from the pandemic, the prices we’re paying at the pump or the grocery store, or the car dealership or the mall remain high. Why? Well, there are serval explanations: The first simple way to look at it is simple hungry profit corporations. If a retailer has seen that people are willing to pay the existing price, then why would they lower it and lower their profit margin?
Second, as a less pessimistic way to look at our capitalist economy, merchants are simply wary of decreasing the price given the volatility of the market and wanting to be ready for any unexpected increase in wholesale prices. Not to mention the cost associated with lowering the price, whether it means updating their software or physically swapping out all the prices tags for new ones. The point? We will have to ride out high inflation coupled with high interest rates for some time before we get the desired result of lower or stabilized prices.
What should you do in times of high interest rates and high inflation?
First and foremost, if you have a variable credit card APR, pay off as much as you can asap, and if that’s not an option, shop around and see if you can find offers with a 12-month, 0% APR and decent transfer fees. Even with the transfer fee, that one-time expense is better than compounding 16%-25% APR month after month!
Next, get the emergency fund set! We’re talking 3 months of income liquid for when the $h@# hits the fan, and you need cash fast. If you’re savings are sitting in an account earning 0.05%, moving that to a savings account earning 1% is an instant and effortless twentyfold increase for your liquid savings!—And it’s very doable via online savings accounts that have lower overhead expenses than the traditional brick and mortar.
Once your emergency fund is set, INVEST! This means stocks, bonds and real estate. This may feel impossible right now with just checking out at the grocery store feeling like highway robbery, but it’s times like these that remind us why building long-term wealth is so critical. With disposable income you are not affected by higher interest rates because you do not have to take out loans to make big purchases (you would only do that in a low interest rate economy because it’s financial advantageous!). Not to mention, the increase in prices, while annoying, are not detrimental to your livelihood. Remember! Paying off some debt and saving or investing something is better than nothing! It’s about the long-game.