Last week, the Federal Reserve cut interest rates for the first time in over a decade in its attempt at keeping the record-long expansion of the American economy going by insulating it from increasingly growing global risks.
The Federal Reserve lowered the benchmark federal funds rate by 0.25 percentage points from 2.50% to 2.25%. The latest reduction in rates was widely expected and actually follows a series of four interest rate hikes in 2018.
The current move to decrease the rate is being viewed as a precautionary measure for protecting the United States from China’s and Europe’s slowing growth as well as uncertainty over President Trump’s trade war. The last time the Federal Reserve cut rates over a decade ago, it was primarily for the purpose of rescuing a failing economy.
The question now is, what should you make of the most recent reduction in interest rates. Here, you will find some of the justifications for the reduction, what it means for you, as well as what you should expect next.
What Slowing Growth?
President Trump might have imposed tariffs on China, but other parts of the globe have also felt the impact. The slow growth of the Chinese economy, partly driven by the fallout from the trade war, has spread to Australia, Germany, and other countries as well. This has resulted in rising supply chain costs, lower exports, and worrying by economic and political leaders.
Germany is particularly a big deal. Exports account for over 47% of Germany’s gross domestic product. With China’s growth slowing, it is having an impact on Germany’s economic prospects since it is its largest trading partner outside the eurozone.
Furthermore, eurozone economies grew by just 0.2% over the previous quarter, which is half the 0.4% growth rate that was posted in the first 3 months of the year, according to Eurostat, which is the European statistical agency. Annualized, the economy grew 1.1% over the same quarter one year ago.
The possibility also exists that Britain might chaotically leave the European Union, and this is proving to be a source of uncertainty for European businesses. Such slowdowns can add pressure on the European Central Bank to intercede, thus preventing a possible recession.
It is this that has driven Federal Reserve policymakers to have an increased level of concern over signs that the extended boom of the United States economy is slowly but surely coming to an end. It is why they announced the 0.25-point reduction in the benchmark interest rate.
What Does the Cut Mean for You?
The rate cut will have several effects, but not all are actually good.
Pros of the Rate Reduction
Lower Mortgage Rates
This is still in contention. Some people believe that fixed rates will drop while others don’t share that sentiment. On the one hand, mortgage rates have dropped already. In fact, as of this writing, the current average 30-year fixed rate is around 3.93%, which is the lowest it has been since November 2016.
Related: Best Interest Rates
One mistake that people often make is to assume that changes in the federal funds rate actually affects mortgage rates. In reality, the mortgage rates track the 10-year Treasury rate, and both have lowered in number by just over 1 percentage point since November since the markets expected inflation and slower economic growth in 2019.
While the 10-year Treasury rates and federal funds rate are usually influenced by similar factors, they are hardly ever affected to the same extent. So, the simple answer is that it is really not clear whether the rate cut will affect mortgage rates, but it is not expected to have a significant impact because they have fallen already. That being said, it’s a great time to refinance your mortgage.
Now, since the variable-rate mortgages and home equity loans are directly tied to the federal funds rate, you can expect a drop in rates on those products, which is quite a massive win.
Drop in Credit Card Rates
The vast majority of credit cards have a variable rate, which means that there’s a direct connection to the Federal Reserve’s benchmark rate.
The prime rate will be lower with a rate cut, and credit cards will most likely follow suit. For cardholders, it means that they may see a reduction in the annual percentage yield or APR within a couple of billing cycles.
On the heels of prior rate hikes, credit card rates currently stand at an average of 17.85%, which is a record high. Considering the fact that most people are still unable to pay their balances in full every month, even a slight reduction in rates could help with the extra money currently going down the drain.
One important thing to note, however, is that credit card contracts typically don’t adjust rates downward automatically. It is still important to contact your credit card company and ask for lower rates and look for opportunities for transferring your balances.
Drop in Auto Loan Rates
Lower rates are a great bonus for people looking to take on new car loans because they will reduce the interest expense as well as help you pay off that vehicle at a lower overall cost.
The latest move by the Federal Reserve will most likely lower auto loan interest rates. While the trend and direction of the federal funds rate influences auto loans, they usually don’t move in lockstep.
Vehicle manufacturers typically finance new vehicles with the interest rate being part of the vehicle-buying transaction. It is obviously important to shop around for the best rate, too, since this can do more in the short term as opposed to waiting to see whether rates drop further.
Decrease in Private Student Loans
Student loan borrowers often rely on federal student loans, which are actually a fixed rate, but over 1.4 million students use private student loans each year to bridge the gap between the cost of college and their savings and financial aid.
Private student loans can be fixed, or may have a variable rate that’s tied to the prime, LIBOR, or T-Bill rates, which means that borrowers will probably pay less in interest when the Federal Reserve cuts rates, although how much less varies depending on the benchmark.
If you have a mix of private and federal loans, you should consider prioritizing paying off the private loans first or refinancing the private loans to lock in a lower fixed rate, if possible.
Cons of the Rate Reduction
Drop in Savings Yields
Savers have only recently started benefiting from higher deposit rates–the annual percentage yield paid by banks to their customers on their money–after the said rates hovered close to rock bottom for a long time.
The Federal Reserve raised the federal funds rate nine times in three years, and the highest yielding rates are currently paying over 2.5% up from 0.1% on average before it started increasing the benchmark rate in 2015.
The deposit rates will drop to some extent after the rate cut. In fact, I just got this sad email the other day from Wealthfront:
In case you can’t read it, they said:
“Because of the Fed’s decision to decrease interest rates, the interest rate on your Wealthfront Cash Account is changing from 2.57% APY to 2.32% APY beginning today.”
Still, online banks are able to offer higher-yielding accounts since they have fewer overhead expenses compared to traditional bank accounts, and savers are able to enjoy considerably higher savings rates if they shop around. (And now it’s dropped another 25 points to 2.07% APY on 9.20.2019)
If you buy CDs, you might see a drop too. CDs typically see a drop in rates in case of a federal funds cut, although such products usually reflect much of the lower yield before the cut is actually implemented by the Fed.
Odd Reaction by the Stock Market
The stock market typically reacts to changes in the Federal Reserve’s policy. Financial market expectations are viewed as a key motivator for the Fed by some and stock indices might decline should the Fed fail to cut as deeply or as quickly in the coming months as is hoped by many on Wall Street.
Still, incorporating Fed actions or expectations into your investment strategy is not a simple task. The best approach for most investors is a diversified, long-term asset-allocation strategy.
The Federal Reserve took a middle-ground approach. It lowered rates by 0.25 points in spite of the economy being stable to mitigate the recession risk. However, the reduction was less than the 0.50 points some economists advocated. Additional cuts might be coming depending on trade and global economic developments.
For now, there’s little to worry about. Do not panic. Instead, take advantage of lower rates for borrowing wherever possible and continue looking for high-yield online savings accounts for a safe investment in your portfolio.
Besides that, there’s nothing much you can do or worry about since it is a relatively minor move by the Federal Reserve. However, you should stay tuned to find out what action the Fed takes over the course of next year.