Why Does the Federal Reserve Control Interest Rates?

The Federal Reserve is mandated by Congress to promote stable prices and maximum employment within the U.S. economy. One of the tools it has at its disposal to achieve these goals is the federal funds rate.

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During times of high inflation, for instance, the Fed will raise its federal funds rate, which is the rate banks charge each other for overnight loans to meet cash reserve requirements.

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When the federal funds rate increases, financial institutions also increase interest rates on certain types of loans, such as credit cards, auto loans, personal loans, and, less directly, mortgages. Many of them also increase the interest rates on their savings products to expand their lending capacity. This makes it more expensive for Americans to borrow money, but it also means they can earn more on their savings balances.

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On the other hand, if the Fed wants to stimulate economic growth, it will lower the federal funds rate. When this happens, loan interest rates also go down, encouraging borrowing and spending among consumers and businesses. The downside is that deposit accounts pay less interest, stunting savers’ ability to grow their savings.

Pros and Cons of High Interest Rates

Depending on your situation, higher interest rates can either help or hurt your financial well-being. Here are some benefits and drawbacks to consider:

• Better savings rates: If you have a lot of cash in savings, you may benefit from higher rates. For example, high-yield savings accounts can offer rates roughly 10 times the national average (or even higher in some cases).
• No impact on existing fixed-rate loans: If you took out a loan with a fixed interest rate before market rates started to climb, your monthly payments won’t be impacted.
• Incentivizes financial discipline: Higher borrowing costs can help discourage taking on impulsive or unnecessary debt, prompting you to focus more on budgeting and saving.
• New loans are more expensive: If you take out a new loan when interest rates are elevated — whether it has a fixed or a variable interest rate — you’ll be charged a higher APR, even if you have excellent credit. This may translate into higher monthly payments, paying more in interest over the life of the loan, and/or having to take out a smaller loan to offset the increased costs.
• Tighter budget: Larger monthly payments on your loans and credit cards could put a strain on your budget, making it more difficult to cover your essential expenses and keep up with debt obligations.
• Other financial challenges: The Fed often increases interest rates during periods of inflation, which means that you could be struggling in other areas of your budget. Minimizing debt is crucial during these periods of economic turmoil.

Pros and Cons of Low Interest Rates

While there are clear benefits to lower interest rates, there are also some potential disadvantages to keep in mind:

• New loans are more affordable: If you take out a loan or credit card during a period of low interest rates, you can expect a lower monthly payment, which puts less of a strain on your budget. Plus, you’ll pay less in interest overall.
• Variable-rate loans may become cheaper: If you have a credit card or other type of variable-rate loan, your interest rate will typically start to come down soon after the Federal Reserve cuts interest rates. Lower payments can give your budget some more breathing room.
• Refinancing opportunities: If you took out a fixed-rate loan during a period of high interest rates, you may be able to refinance at a lower interest rate, reducing your monthly payment and saving on total interest charges.
• Savers won’t earn as much: With lower interest rates, you likely won’t earn much on your savings account, money market account, or certificate of deposit (CD).
• Possible strain on retirees: Those who rely on interest income from savings and bonds will see reduced returns, which could impact their ability to cover living expenses.
• Risk of inflation and asset bubbles: When interest rates are lower, spending generally increases, which could cause prices for goods and services to rise. Additionally, lower borrowing costs can lead to inflated prices for real estate and other assets.

The Bottom Line: Are High or Low Interest Rates Better?

There’s no right answer when it comes to whether a high or low interest rate environment is best. Ultimately, it depends on what is best for the current economic situation and your personal financial goals and needs.

Typically, low interest rates are best following an economic downturn when the Fed needs to stimulate economic activity. At the individual level, low interest rates are ideal if you’re interested in taking out a large loan (such as a mortgage) or could benefit from refinancing an existing high-interest loan.

On the other hand, high interest rates are good for managing inflation and stabilizing prices. If you’re trying to save more money and looking for low-risk ways to grow your wealth, higher interest rates can help too.