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How Federal Funds Rate Affects You

So we’re on the verge of another rate hike by the Fed, but what exactly does it mean for you personally? I’ll detail a bit of the mechanics of what is generally understood about the far-reaching effects of a federal funds rate hike (which is what people mean by a rate hike) and give you an idea of what to expect.

1. The act that gets the ball rolling is the Fed raising the target for short-term rates by pulling out money from the reserves, thus increasing the federal funds rate.
2. It is not more expensive for banks to borrow money so they pass on that expense to folks who borrow from them, by increasing their prime rate.

Here is where things get interesting…

For businesses and the overall “market”, they have to pay higher interest rates for all their loans, which increases their costs. This has the effect of potentially weakening the stock market as businesses will earn less profit because of higher interest rates. Bonds are a little trickier because their rates may improve or get worse based on sentiment and future expectations. It may sour if folks believe higher rates are to come (why lock in now when you can get a 3 month CD and get better rates later) or sweeten if folks believe things will remain stable.

For a consumer, you’ll see higher rates on all of your loans too – credit card rates, mortgages, home-equity lines of credit, etc. You may also see higher interest rates on your deposit accounts (savings, checking, CDs, money markets, etc) too. This will result in a decrease in spending, again, slowing down the economy.

Ultimately, the effect on the economy is that the higher cost of loans will slow down economic growth (businesses and consumers can’t borrow/buy more). This is what they mean when they say a rate hike combats inflation. The interest rate hike also has positive implications on the value of the dollar because it increases the cost of exports.

Update: (5/5/05) Bankrate has a great article about this here [3], detailing if you’re a winner or loser when the Fed raises rates. It follows the basic trends I’ve outlined.