On September 18, 2024, the Federal Reserve lowered the target range for the federal funds rate by half a percentage point—marking the first time in four years the rate hasn’t been raised or kept the same.
In an issued statement, the committee said it has “gained greater confidence that inflation is moving sustainably toward two percent, and judges that the risks to achieving its employment and inflation goals are roughly in balance.”
With the headlines dominated lately by news of slashed interest rates, it’s easy to get swept up in the excitement. While this is good news for many reasons, as both an investor and a consumer, it’s important to understand how lower interest rates may affect your day-to-day life and long-term financial plan.
Let’s take a look at how we got here and what to expect next as interest rates drop.
How Does the Fed Set Interest Rates?
Before we get into the ripple effects of a rate drop, it’s helpful to understand how the Federal Reserve sets rates to begin with. Contrary to popular belief, the Fed doesn’t control inflation, at least not directly. What it does control is the federal funds rate.
What Is the Federal Funds Rate?
Banks are required to keep a minimum amount of reserve cash on hand. At the end of any given day, a bank may have more or less than the reserve requirement it needs to operate the following day. When this happens, the bank can either loan or borrow cash overnight at a rate of interest determined by the Federal Reserve. This interest rate is known as the federal funds rate.
Typically, the longer the length and riskier the terms of a loan are, the higher the interest rate will be. Since this type of bank-to-bank loan, also called overnight lending, is the shortest possible term length and is low risk, by setting the rate, the Fed essentially determines the low end of the spectrum for all types of lending. Banks pass on the expense of these loan terms to consumers through prime rates, which trickle down to impact the whole economy.1
Why Have Rates Been So High?
If the Fed sets rates to maintain price stability and reduce unemployment, then why has inflation been so high? Again, the Fed doesn’t control inflation. It creates the benchmark for the cost of borrowing money, which helps control inflation.
After COVID-19 rocked the economy in 2020, businesses were faced with a shortage of workers, which impacted their output. At the same time, many Americans received stimulus checks, which meant an increase in spending. The simultaneous scarcity of goods and rising demand meant prices skyrocketed.
The federal funds rate hovered between 0% and .25% from March 2020 to March 2022 in an effort to keep the economy afloat. Once inflation began rising, the Fed gradually increased rates to 5.25% by July 2023, the highest rate in 23 years.2
How does this work to counter inflation? When it’s more expensive to borrow money, demand for everything is reduced, forcing businesses to lower prices in order to stay competitive. Now that inflation has cooled off, the subsequent lower rates should make way for more economic opportunity.
What Should You Expect from a Rate Cut?
So, what does this mean for you and your financial future? There are a number of implications we can anticipate.
Impact #1: Debt Becomes Less Expensive
As we established, lower rates pave the way for economic growth. Cheaper loans mean taking on new debt or making a significant purchase is back within reach for many Americans.
Consider the mortgage payment for a $1,200,000 house purchased in 2021 at 3% interest with 20% down ($240,000). For principal and interest (excluding taxes or insurance), you would pay $4,216 on a 30-year fixed rate $960,000 loan. With a salary of about $200,000, that equates to about 25% of your monthly, pre-tax income. Fast forward, the same $960,000 loan at a 7% interest rate means your monthly mortgage payment would jump to $6,653, making the same property at the same price materially less affordable as it now makes up 40% of your pre-tax income.
As interest rates drop, more people may be able to afford major purchases, like home and car buying.
Impact #2: Unemployment Rates Tend to Drop
Debt affordability isn’t limited to home loans. Lower interest rates enable businesses (especially larger corporations) to take on more risk as they work toward expansion and growth—which eventually, can lead to more job creation and a stimulated labor market. This, in turn, translates to more spending, as increased income creates the capacity for a robust economy.
Impact #3: Cash Equivalents Will Lose Some of Their Star Power
Costlier loans aren’t always bad for consumers. For instance, the high rates of the past few years meant money market funds and high-yield savings accounts were generating nearly unheard-of rates—it wasn’t unusual to see upwards of 5% or more.3
While the past few years may have been a challenging time for borrowers, it did create an opportune time for lenders and savers to enjoy higher-than-usual returns. As rates drop, it’s likely that interest rates on certain savings accounts will begin moving back down to more historically average rates.
Impact #4: Investor Sentiment May Shift
In general, investors don’t like change—and we can see those fears and anxiety manifest in the form of market volatility when a sudden or unexpected change does occur. While lower rates are generally a positive indicator for investors, it’s also just one economic factor brought into consideration. Rates have begun to come down, but other data—such as lower inflation and an uptick in unemployment—indicates some economic slowdown, which can spook investors.
So, what does that mean for your investments? In reality, any shift in investor sentiment as a result of lower rates will likely be short-term in nature (as has been the case historically speaking). If you’re working with a long-term investment strategy, your portfolio should be built to weather the volatility. However, you can always reach out to your advisor if you have questions or are concerned about market movements.
Impact #5: Tax Penalties May Be Lower
Lower interest rates across the board could benefit you in surprising ways—including at tax time. If you’re late paying your taxes, the IRS may charge you interest on underpayments, which is calculated quarterly at the federal short-term rate plus 3%.4 Conversely, the IRS pays interest on overpayments, which is also based on the Fed’s short-term rate.
Stay the Course
We can expect some changes to come on the heels of a Federal Reserve rate cut, though there’s also much we don’t know (such as when rates may drop again, or by how much, and whether markets react atypically). Planning for your financial future requires careful thought, insight, a strategic approach, and a steady hand.
We believe authentic conversations blaze a trail for informed decisions, which is why we’re always available to answer your questions and help you understand how to navigate your wealth. If you’re not sure whether or not you’re on the right path to reach your goals, we’d love to hear your concerns and identify solutions to set your mind at ease. Reach out to start the conversation today.
Sources:
1 Overnight Rate (Federal Funds Rate): Definition and How It Works
2 Federal Funds Rate History 1990 to 2024
3 Savings Accounts Are Paying Record Rates Today, Feb. 13, 2024. How Long Will They Last?
4 Topic no. 653, IRS notices and bills, penalties and interest charges