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Low interest rates are here to stay for the near future, but expect higher inflation in the coming years.
The Federal Reserve recently announced their biggest changes to its policy on inflation, which is how much our money devalues over time relative to what we can buy with it. Inflation is the reason, for example, candy bars that used to cost only 20¢ each when I was a little kid now cost over $1.
These changes not only affect the future value of our money and investments, but also the entire economy and how much we get paid by some of our mitochondrial accounts (i.e. savings accounts).
So is this a good thing or a bad thing and how important is it?
Well, changes made to any of the Federal Reserve’s policies are always important as they will affect all of us in one way or another. This may be good news for you or really bad news for you depending on what you do with this information.
Here’s how the Fed’s new policy will affect you and your finances, and what it means for the real estate market, stock market and inflation (the value of your money).
Related Article: Higher Inflation – What Does This Mean For All Of Us?
What is the Fed's new policy on inflation?
Before these changes, the Fed had set a target inflation rate of around 2% per year. This means our money is loses $2 in value every year. In simple terms, you can think of it like this:
Now the Fed basically said they are less concerned about letting inflation run high and is targeting an inflation rate that averages 2% over time. This means that following a period of low inflation, like the one we’ve been having in the past year or so, the Fed might allow inflation to run above 2% for a period of time. We could see inflation rates as high as 6% and the Fed would be OK with it as long as the inflation rate averages to 2%.
As you can see from the graph below, the Fed has failed to consistently reach their target 2% inflation rate for consumption expenditures (excluding food and energy) in the past decade. The average was about 1.6% over the past 5 years. With the Fed’s latest changes, they would be fine letting inflation run as high as 4% the next year to bring the average closer to 2%.
Normally the Fed would attempt to influence and control inflation by changing the federal funds interest rate, which is the interest rate on overnight loans between banks.
How does the federal funds rate affect inflation?
Well, it has to do with the federal funds rate, which you can read more about here.
But here it is in a a nutshell.
When inflation is low, the Fed would normally lower the federal funds rate so that it is easier for banks to obtain money from other banks. When banks have more money, they can lend more money to people, which means people can spend more money.
And because it is cheaper for banks to borrow money from each other, they can lower the interest they charge you, making it even more affordable to borrow money for spending. Lower interest rates make it easier and incentivize people to borrow money. More money means more spending and more money injected into the economy which causes inflation to increase.
Now, here’s the catch.
Since the federal funds rate is so low, interest rates on the whole is going to be lower as banks adjust their rates on everything from bank accounts to credit cards to mortgages. This can be both a good and bad thing.
Let’s look into what this means and how it will affect your finances.
Low interest rates
After the Fed announced they cut interest rates to 0% back in March of this year, you may have noticed the interest rates that most of us are familiar with, including credit card interest, mortgage interest and other loan interest aren’t exactly 0%.
Well that’s because they were referring to the federal funds rate and it isn’t quite 0%. They set a target range of 0% to 0.25%, the latter of which is the current federal funds rate. So it’s not 0% but it is close enough.
Again, because it is cheaper for banks to lend money to each other, usually on an overnight basis, banks can lower the interest rate on the money they lend to us.
Low mortgage rates
You may have seen or heard how mortgage rates have gone down by a significant amount. Prior to the pandemic, the average interest rate on a 30-year fixed mortgage was about 4.5%. Now the average interest rate is 2.93% (at the time of writing) and expected to keep on going down.
This makes sense since it’s cheaper for banks to borrow money from each other and therefore can lower the interest rate for us. These low rates, however, may only stay for the next two years and you may see an increase in the rates from time to time.
This is because mortgage rates don’t respond directly to changes on the Fed’s part. The Fed sets borrowing costs for shorter-term loans with the federal funds rate and fixed mortgages have long-term interest rates (15 and 30 years). Adjustable-rate mortgages, however, do respond directly to the Fed’s changes in the federal funds rate.
Instead, fixed-rate mortgage interest rates go up and down along with long-term bonds, particularly the 10-year Treasury rate, mortgage-backed securities, and demand.
Long-term bonds on mortgage rates
The 10-year Treasury are bonds issued by the government that matures in 10 years. In other words, they are IOUs investors give to the government that needs to be paid back with interest in 10 years.
Although the 10-year Treasury rate may not change in response to the federal funds rate, a cut in the rate can cause investors to worry about the economy, causing them to invest more in the Treasury, which is considered a safe asset. This is because the government just doesn’t default on their loans.
Having more investors turn to the 10-year treasury causes to the rate to go down, which in turn causes the mortgage rates to go down.
But, the 10-year Treasury is not really what’s causing the interest rate to go down.
Mortgage-backed securities on mortgage rates
What’s really causing low mortgage rates is the Fed buying what’s called mortgage-backed securities (MBS), which are bundles of home loans a bank sells to investors.
When you take out a mortgage, the bank has the option of keeping the loan or sell your loan to investors by bundling it with other mortgages in what’s called a mortgage-backed security. Banks sell your mortgages to investors like other banks to free up cash and resources so that they can issue more loans. Instead of profiting from the interest you pay over the lifetime of the mortgage, they make money from the fees associated with MBS while the investors profit from your interest payments.
The Fed is the biggest MBS investor right now due to the COVID-19 pandemic. To make money easier for people to borrow in an effort to stimulate the economy, the Fed has bought $1 trillion in MBS since March. Whenever there’s a lot of demand for MBS, mortgage interest rates drop because each MBS can be sold for more, making the return on investment less for investors.
The Fed plans to continue to purchase MBS at their current rate until the end of 2020 so you can expect mortgage interest rates to keep going down, but you may see an occasional increase due to demand.
Related Article: How the Fed Affect Mortgage Rates
Takeaway on Mortgage Interest Rates
The Fed plans to continue to purchase MBS at their current rate until the end of 2020. As long as the Fed keeps on buying MBS you can expect mortgage interest rates to keep going down, but you may see an occasional increase due to demand. Banks may increase their rates so that they can keep up with the demand.
These low rates may be only temporary. Once the COVID-19 pandemic recedes and a new normal is established, the Fed may not see a need to keep buying MBS. And when they stop, expect rates to go up. If you have been thinking of moving or purchasing a home, now and the next year is a good time to lock in a low interest rate for the next 15 to 30 years.
Save on credit card interest
Variable or adjustable interest rates like credit card interest rates go up and down with the federal funds rate. So when the Fed slashed the federal funds rate to near 0%, your credit card interest also went down and they should remain “low” for the foreseeable future.
Though credit card interest rates did go down, they did not go down by much. The current average credit card APR is 16%, which is well above the rate of other types of loans. That is down from 17.68% a year ago according to CreditCards.com, which amounts to about $8 a month in savings if you just make minimum payments toward the average credit card debt of $5,700 (according to the Fed).
As you can see it’s not much and you do not save a whole lot of money. Credit card interest rates may continue to drop but it likely won’t drop by much. The best is to avoid this interest all together and practice good credit card habits by paying off your balance in full each month.
Your high-yield savings accounts will not pay you as much
Like credit cards, the interest rates earned with high-yield savings accounts and certificate of deposits (CDs) also depends on the federal funds rate. Unfortunately, this means these accounts won’t pay you as much as long as the Fed keeps the interest rate low, which they are for the next couple of years to let inflation run higher.
Many banks offered APYs for high-yield savings accounts of 1.8% to over 2% before the COVID-19 pandemic. Now interest rates range from 0.65% to 0.9%. This means for every $1,000 saved, you earn $6.50 to $9 every year.
That may not be a lot but the good news is that some banks are still giving high interest rates. T-Mobile Money, which I opened last month, still provides 4% for the first $3,000 (though you need to be a T-Mobile customer) and 1% for anything above. The other good news is that banks are still paying you interest for banking with them even though it may not be much.
When inflation picks up, banks could increase the interest on these accounts and we may see rates return to what they were before the COVID-19 pandemic.
Related Article: 5 Best Bank Accounts To Earn Free Money In 2020
Higher Inflation
The Fed cut the federal funds rate to near 0% and is planning on keeping it there for the next couple of years – through 2023 – just so they can let inflation rise.
With interest on the whole being low, inflation is expected to increase as it is easier to borrow money and therefore easier to spend money. Higher inflation means the cost of goods and services will go up and it could go up by a lot now that the Fed is content with letting inflation run loose as long as inflation averages to 2% in the long run.
Here’s what higher inflation means and what you should do with your money.
You are losing money if you are only saving
Having higher inflation is not necessarily a bad thing. It stimulates the economy by incentivizing people to spend their money. This can actually be good for you because your money loses value the longer you keep it and don’t spend or invest it.
By spending your money you will be able to buy more with each dollar you have. And by keeping your money, especially if you keep it in vacuoles (no interest account), you will be losing it as the value of your money loses gets eroded by inflation.
In order to prevent losing money to inflation, you should keep your money in mitchondrial accounts that give you ATP (Assets, Tax advantages, and Pay). These include high-yield savings accounts that pays you interest every year just by keeping your money in them and investment accounts such as brokerage and retirement accounts that allow you to grow your money by investing it.
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You are losing money if you are not investing
The stock market has soared and reached all time highs since the first few weeks following the beginning of the COVID-19 pandemic despite a looming recession. And it has only gone up higher and higher from April to September.
This means it was more expensive to purchase stocks the longer you waited during that time frame. I know I wish I had more cash to invest back in March and April, but I did not and now it is more expensive to purchase the same stocks I wanted to back then.
Generally stocks go up with inflation so the market could still go higher as inflation ramps up in the near future due to the Fed’s effort in keeping interest rates low for the next couple of years. The higher stock prices go up, the more you make from your investments and the more it will cost to purchase the same stocks.
This is not to say there will not be another stock market crash or stocks will only go up. No one knows what will happen but long term, stock prices will likely be much higher than they are today.
Final Thoughts
Low interest rates are here to stay until at least until 2023 thanks to the Fed’s decision to keep the federal funds rate low and them buying MBS.
If you are looking to purchase a property, whether it’s for your primary residence, vacation home or rental property, now and the next year is a great time to take advantage of low interest rates and lock them in for the long term.
If you have at least 6 months worth of expenses in emergency savings, any extra money that you have no purpose for other than just sitting there in your bank account should be invested or at least saved in a high-interest account. Keeping more too much cash on hand without a plan causes that money to lose value over time. Instead, that money could be invested with a long-term outlook to outpace inflation.
So is this good or bad news for you and how will you respond to this information?
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