April 2023
Interest rates are the cost of borrowing money or the reward for lending it. The Federal Reserve sets the federal funds rate, which is the interest rate banks charge each other for overnight loans. The federal funds rate then affects other interest rates in the economy, like the ones you see on your mortgage, credit card, savings and money market accounts. The Fed adjusts the federal funds rate depending on changes in the economy. If inflation is high, they raise it to cool things down. If unemployment is high, they lower the federal funds rate to boost the economy.
From 2009 to 2022, interest rates were at record lows. In 2009, to stimulate the economy after the Great Recession, the rates were 0% to 0.25%. These rates stayed there for years and started to rise slowly to 2.2% in 2019. However, in response to the COVID-19 pandemic, the Fed again lowered the rate to near zero in March 2020.
Then things changed again in 2022. The economy was growing fast, but so was inflation. The Fed had to deal with a tricky situation of rising prices and strong demand. In response, the federal funds rate has risen nine times since the beginning of 2022 to the current rate of 4.8%. It is the fastest rate increase in US history and resulted in the worst performance of bonds in 40 years. In fact, the Federal Reserve is guided by lessons learned 40 years ago when the Fed rate was eventually raised to 21.7% to combat persistent high inflation.
How do interest rates impact you? If you're borrowing money, it means you have to pay more interest over time. Mortgages have gone up. For a credit-worthy borrower, the national average for a 30-year mortgage now is 6.8%. However, this rate may be higher or lower, depending on various factors, including location. This is much higher than the record low of 2.7% in December 2020, yet close to the rates between 2006 and 2008, which were around 6%. Consider the impact on the economy that such a change can have on housing, a significant driver of the overall economy. Some would-be home buyers suddenly can’t qualify for a mortgage. Homeowners won’t sell because they don’t want to give up the low rate on their current mortgage. There’s data that also shows there has been some damage in banking, commercial real estate, auto financing and manufacturing.
If you have savings, higher interest rates should mean a higher return on your bank accounts. For years savings accounts, Certificates of Deposits and money market accounts were paying next to nothing because of the low federal funds rate. You’ll never get rich buying CDs, but interest rates have gone up. The national average one-year CD rate is 1.68%, but many banks offer much higher rates with special offers of 4% to 5%. The higher rates for CDs are generally limited to a two-year term. Meanwhile, mutual fund money market funds are earning a decent return for the first time in over fifteen years. Vanguard’s Money Market Federal fund currently yields 4.8%.
CDs earn a fixed interest rate for a fixed amount of time, but you generally can’t withdraw funds before the term is over without sacrificing some or much of the interest you’ve earned. While CDs with higher yields are not a bad idea to have as a security blanket, they will rarely beat inflation. Due to the fixed amount of time, you should not store cash for your emergency fund in a CD. You must be diligent when a CD matures, as you typically have just ten days to withdraw the funds before it auto-renews at the new current rate, which could be significantly lower than what you were getting.
Most banks have FDIC insurance. Vanguard is covered by the Securities Investor Protection Corporation up to $500,000 per investor with a limit of $250,000 on money market funds. Coverage does not extend to market losses. The Fed jumped in at Silicon Valley Bank because it had assets of $210 billion. Do you think it will get involved if Vanguard ($8 trillion) had a similar problem?