Before scheduled Federal Reserve meetings, you'll hear a lot of speculation about what the Fed will do. These speculations affect the stock market. Media reports also speculate about the effect of possible interest rate changes on consumer credit cards, mortgages, and auto loans.
Despite this kind of media attention, the interest rate changes do not directly affect consumers. When the Fed announces a change in interest rate, it does not affect your credit card interest rate directly. It refers to the interest rate the Fed charges commercial banks to borrow money from the Federal banks. This is also called the discount rate.
The Fed changes the discount rate to make it more or less profitable for commercial banks to borrow money. The banks use this borrowed money to make loans to their customers.
The two critical points to remember are: 1. The Federal Reserve system exists to control the amount of money in the system. 2. The banks exist to make money by loaning money to their borrowers.
It is a matter of profit. If the banks must pay more to borrow money whenever the Fed raises the interest rate, the banks make less profit from their loans to customers. If the banks can pay less to borrow money whenever the Fed decreases the interest rate, the banks increase their profit from loans to customers.
Even though this change directly affects banks, Fed rate changes affect all of us, because they change the speed of money. If banks can loan more money at lower costs to the banks, the increased loans will increase the amount of money available in the entire economic system. If the banks have less money to loan, because the banks have to pay higher rates to borrow the money, money will increase more slowly.
The bottom line fact is that the Fed does not change consumer interest rates. The banks might decide to change interest rates on credit cards and adjustable rate mortgages, but these changes are not directly tied to any changes the Fed makes in the rate it charges banks to borrow money.
