The Federal Reserve announced yet another interest rate cut at its penultimate meeting of 2024, bringing it to a range of 4.5–4.75%. This is the second rate cut this year, approved by the Fed as inflation has finally started moderating.

While this latest cut is one the markets already expected, some analysts wondered whether the elections would influence the Fed’s monetary policy, a concern addressed by the Fed’s president Jerome H. Powell in his press conference.

“In the near term, the election will have no effects on our policy decisions,” Mr. Powell said. “We don’t guess, we don’t speculate, and we don’t assume.”

But before we get into what this all means for you, let’s talk about interest rates — what they are, how they work, and how the Fed decides what they’ll be.

What people mean when they talk about “interest rates”

Usually, they’re talking about the target federal funds rate, aka the fed funds rate, aka “short-term interest rates.”

What’s the federal funds rate?

By law, banks that accept deposits from people are required to keep a certain amount of cash on hand so people can withdraw money. That amount is called their “reserve requirement,” and it’s based on a percentage of the total amount of money that people have deposited at that bank.

But the amount of cash a bank has on hand changes as people go about their business depositing and withdrawing their money. If, at the end of the day, a bank thinks they’re going to have more cash on hand than they need to fulfill the reserve requirement, they can lend some of their extra to another bank who thinks they’re going to come up short. The interest rate banks charge each other on these loans is called the federal funds rate.

The Fed sets a “target” rate

Eight times a year, the Federal Open Market Committee (FOMC) — a group of people from the Fed in charge of setting monetary policy — gets together to decide what the ideal federal funds rate should be, based on how healthy the economy is (more on this in a minute). They can also meet outside their regular eight-meeting schedule if the economy is volatile.

But the FOMC can’t just dictate how much banks can charge each other; that happens via negotiation between the two banks in question. So instead, the FOMC sets a target federal funds rate between a certain range.

The actual rate banks end up charging one another is called the effective federal funds rate. In order to get that into the target range, the FOMC either adds money into the financial system, which increases supply and lowers the effective rate, or they take money out of the system, which decreases supply and increases the effective rate.

How the federal funds rate affects you (and the economy)

The federal funds rate affects how much banks pay to borrow and lend, and so it impacts how much they charge you for other financial products and causes a ripple effect on other interest rates you might encounter in daily life. That’s what makes it a useful tool for the Federal Reserve when it comes to influencing the health of the economy.

Lower rates give the economy a boost

Typically, when the federal funds rate decreases, so do the interest rates paid out on saving products, like savings accounts and certificates of deposit (CDs). But it also tends to lower the interest rates you’ll pay for debt products, like automobile loans, personal loans, and credit cards.

This makes it less worthwhile to save money, and more worthwhile to borrow money, which encourages people to save less and spend more. So when the economy needs some help, the Fed can lower rates to boost economic activity (aka spending). That’s why the Fed lowered rates to zero in March 2020 (and kept them low for so long).

Higher rates help curb inflation

It works the other way, too: When the federal funds rate increases, so do the interest rates you can earn on things like savings accounts, and the ones charged for things like loans and credit cards.

This makes it more worthwhile to save money, and less worthwhile to borrow money, which encourages people to save more and spend less. So when the economy seems like it’s growing too fast, which can lead to inflation (sound familiar?), the Fed can raise rates to slow economic activity.

What this news tells us about the future

As a refresher, for two full years, the federal funds rate was set at 0% to help the economy through the pandemic. But then inflation spiked — and stayed elevated. Plus, the job market was still abnormally hot. So they raised rates at record speeds, and over the past year, left rates up to the range of 5.25–5.5%. Finally, inflation has been slowly but effectively cooling off, with minimal effect on the job market.

As inflation paces toward the Fed’s goal of 2%, bringing the economy to a “soft landing” (aka bringing inflation down without causing a recession), we may see more cuts to come. They’re expected to approve at least one more rate cut before the end of the year.

What does this mean for you? Well, outside of inflation, other areas have been slow to respond the these rate cuts — mortgage rates, for example, remain stubbornly high — but that doesn’t mean they’re not working.

“It takes some years of real wage gains for people to feel better,” Mr. Powell said. “That’s what we’re trying to create. And I think we’re well on the road to creating that.”

The bottom line on interest rates

TL;DR: Rates go down: borrowing good, saving bad (or less attractive, anyway — saving is never bad). Rates go up: saving good, borrowing … not so much. However, most consumers won’t see an immediate impact from this aggressive rate cut on their finances. Financial institutions are a lot slower to cut rates than the Fed. But as always, it’s impossible to know for sure what will happen next.

That’s why, at the end of the day, our advice is (always) this: Stay the course, keep investing, and build a strong financial plan.

Disclosures