How Federal Rate Cuts Affect Your Savings Account Interest Rate
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So for the past two years, we’ve watched the Dow Jones tumble… and 401k’s emptied… and people lost jobs… and banks collapse… and foreclosures everywhere… and so much more. With the constant bombardment of dismal financial news, one thing we often hear and read from the media is: the Fed has cut rates and is keeping them near all-time lows.
It used to be such a pleasant sight when high-yield online savings accounts like HSBC Direct Advance and ING Direct were offering interest rates upwards of 5%. Back when the Fed dropped rates whenever it deemed necessary, I’d feel a bit of disappointment, as I knew the interest rate in my savings accounts would drop as well.
How Does That Happen?
Firstly, you should know that the federal funds rate is a target rate that the Federal Reserve strives for – it is not set in stone. This is the rate at which banks (such as Bank of America and Chase) borrows funds from Federal Reserve banks for whatever reasons they may have – but most notably, for lending purposes through mortgages and credit cards.
Banks are businesses that profit from lending your money at a higher interest rate than the interest rate on your savings account. So, a bank needs money to make money. Sources of money include customer deposits (such as those from you and I) and federal funds.
The bank’s cost to acquire capital is what determines the interest rates on depositor accounts. Banks have no direct control over the Fed rate but they can change the interest rate on their financial products. When the Federal Reserve announces a rate cut, it is becomes cheaper for banks to raise capital through borrowing federal funds than to attract deposits through offering higher interest rates. So, banks will reduce interest rates on savings accounts accordingly.
The demand for loans and credit has taken a plunge during the recent recession. With the government placing blame on banks for irresponsible lending that caused the credit crunch and the fall of the housing market, stricter lending ensued. Since banks aren’t lending as much, they don’t need as much of our money.
An Economic Force
The federal fund rate is such a big deal because it is a seemingly simple term but it has a drastic effect on the economy and is therefore a powerful tool in enforcing monetary policy. A rate cut lowers the cost of credit through lower interest rates, which encourages more borrowing and less saving with the goal of jumpstarting the economy – they want us to spend.
We will see high-yield savings accounts with interest rates higher than 5% when the U.S. economy experiences stellar growth – a time when the Fed raises rates so the economy doesn’t grow too quickly. Until then, we must live with the measly 1+%.
(Photo credit: LateNightTaskForce)
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