How fed funds rate drop affects you

The Fed decided to lower its target for the Fed Funds rate by 50 basis points on Tuesday, the Dow Jones rallied immediately, posting the largest one day gains it’s seen since 2003. So what does all this mean for you?

Well, the Fed Funds rate doesn’t directly affect mortgage rates, but mortgage rates are down since last week, so let’s examine exactly what happened, and why it may or may not last.

In simple terms, mortgage rates dropped because investors were pleased at the Fed’s decision to lower the Fed Funds rate, when investors are happy and confident in the US Economy, mortgage rates will generally go down, and that’s exactly what happened on Tuesday.

On the other hand, low interest rates can lead to inflation if the Fed doesn’t remain vigilant. The Fed Funds rate is only a target interest rate; in other words, the Fed doesn’t just come out of its meeting and say, “Let the Fed Funds rate be 4.75%,” and it just happens. The Federal Funds Rate is the rate at which banks lend money to each other, usually overnight, in order to ensure each is meeting the cash reserves it’s required to maintain. If one bank has more than it needs, it lends money to a bank that doesn’t have enough; the rate these banks charge each other is called the Federal Funds Rate. To drive the Fed Funds rate down, the Federal Reserve, in a roundabout way, pumps cash into the banking system. If banks have more cash, there is less demand for interbank borrowing, which leads to a drop in the Fed Funds rate.

Ideally, the cash the Fed pumps into the banking system will be just enough to keep the economy balanced. If the Fed pumps too much money in, banks find themselves with a bit of a surplus, which finds its way into the pockets of you and me. If everyone has more money, they spend more, which means higher demand for products and services, which leads to higher prices for products and services, which is called inflation. So the Federal Reserve has a real balancing act to play in the US economy.

If inflation starts to increase, mortgage rates will rise again simply because investors will demand a higher rate of return to counter inflation. So, while the Interest rate drop will spur the economy in the short term, what happens in the long term is anyone’s guess.

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