It may seem like a small change, but a shift in policy by the Federal Reserve could impact everything from how much you pay for goods and services to your loan’s interest rate. Recently, the Fed announced it would aim for an average 2% rate of inflation. In year’s past, the Fed tried to keep inflation as close to 2% as possible. Why the change?
The Fed’s decision to be more flexible regarding interest rates stems from a concern about the economy. Historically, the Fed has focused on the “stable prices of goods and services” portion of its two main objectives (the other objective is promoting maximum employment). The 180-degree change suggests the agency has signaled a willingness to engage in a balancing act.
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Letting inflation rise means things like groceries and gasoline will become more expensive. Getting those costs under control is typically achieved by raising interest rates, and that can impact everything from your mortgage to your student loans.
4 things to know about the policy
Fiscal policy can be a bit convoluted. It can be difficult to sift through the jargon to see how the Fed’s decisions affect everyday life. To help, here are four big things to understand about the Fed’s latest move.
- It’s important to understand the relationship between interest rates and inflation. Generally, individuals and businesses borrow more when interest rates are low because it will cost them less in the long run. More money in the system translates to more spending, which can lead to job growth. But prices will rise. When interest rates are high, people tend to hold onto their money because they get a better return on investments like savings accounts.
- The decision to let inflation rise and fall comes with some caveats. The current inflation rate stands at 1% for the 12 months ending in July. This low rate is part of a long-term trend. The Fed wants to see interest rates climb out of a concern for the job market. However, Federal Reserve Chairman Jerome Powell didn’t provide specifics about what level of a rate increase the Fed would allow. In an interview with CNBC, Dallas Fed Chairman Roger Kaplan gave a range of 2.25% to 2.5%.
- When inflation goes up, prices go up. Put simply: households will have less buying power.
- One of the best ways to bring inflation back down is by raising interest rates. Doing so carries a degree of risk, as it can stifle growth — especially in the job market.
Is this framework good for the economy?
Jobs are the big takeaway from Chairman Powell’s remarks. In his speech, Powell noted the combination of low inflation and low interest rates limits “our ability to stabilize the economy by cutting interest rates.” Powell noted prices for essential items such as food and gasoline could burden families, but stressed the need to raise inflation to prevent more considerable economic harm.
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“A loosened Fed policy will bring much more volatility and uncertainty into the economy and markets as a whole, which will present both opportunity and challenges,” said Sal Gilbertie, President of Teucrium Trading. “Overall, this new policy will be good for the economy and economic growth, but in a less constrained environment, which will naturally be more unsettling at times for many people.”
How will the new policy framework affect rates?
The federal funds rate heavily influences the interest rate you pay on a mortgage loan or a credit card. This rate is a tool the Federal Reserve uses to promote economic stability. The Fed can adjust this rate to either raise or lower the cost of borrowing. Right now, the federal funds rate stands at 0.25%. The rate was dropped to near zero at the start of the pandemic to encourage spending. So, how will the Fed’s new policy impact federal funds and things like mortgage rates, yields on savings accounts and student loan interest rates?
Mortgage interest rates
Raising interest rates is one way to keep inflation in check, but don’t look for that to happen anytime soon.
“The Fed is essentially saying that interest rates will be much lower in the long-term and that the inflation portion of the dual mandate will be less important than maintaining employment,” said Adem Selita, CEO and Co-founder of The Debt Relief Company.
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The interest rate on the 30-year fixed mortgage has been below 3% for six of the past seven weeks. The most recent data puts the rate at 2.91%.
Yields on savings accounts
The pandemic hit high-yield savings accounts particularly hard, but rates are still at 1%, significantly higher than returns on traditional savings accounts.
“These rates tend to correlate with the prevailing Fed Funds rate,” said Gilbertie. “Right now, you’re not getting better than 1%. If rates go back to where they were one to two years ago in response to inflation pressures, these will follow.”
Student loan interest rates
In August, President Trump signed an executive memorandum that extends protections issued under the Coronavirus Aid, Relief, and Economic Security (CARES). The memorandum suspends payments on all Federal student loans until the end of the year while also keeping interest rates on these loans at 0%. These protections don’t apply to private loans where interest rates and forbearances vary by lender.
“Private loans tend to charge what the market will bear,” said Gilbertie. “With fewer students going to college this year and possibly in the years ahead, those rates might actually come down in order to spur demand.”
Too long, didn’t read?
The Federal Reserve recently announced a change in policy toward an average 2% rate of inflation. In recent years, the Fed has tried to keep inflation as close to 2% as possible. This shift means inflation will be allowed to rise, which will impact the cost of everyday items like food and gas. Raising interest rates is one way to keep inflation under control. The Fed’s rethinking of its inflation policy underscores larger concerns about the economy and a focus on the job market.
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