6 key ways the Federal Reserve impacts your money

Did you buy a home when mortgage rates were at record lows in 2020? Did you job hop during a so-called great resignation of workers in 2021? Have you been holding off on buying a new home or a car until you can find a cheaper deal and lower interest rate?

Believe it or not, those decisions might be linked to what’s happening at the world’s most powerful central bank: the Federal Reserve.

What does the Federal Reserve do?

The Federal Reserve is the central bank of the U.S., one of the most complex institutions in the world. The Fed is best known as the orchestrator of the world’s largest economy, tasked with price stability and maximum employment. The main way the Fed guides the economy toward those goals involves determining how much it costs businesses and consumers to borrow money.

Cheap borrowing costs can be the difference between businesses choosing to hire new workers or invest in new initiatives. Expensive rates, however, can cause both businesses and consumers to pull back on big-ticket purchases — as well as hiring.

After raising interest rates a whopping 5.25 percentage points since March 2022, the Fed looks more likely to cut interest rates than raise them. Inflation, however, is still stubborn, and the rate environment is unlikely to shift materially until the Fed feels confident that inflation is slowing — assurance that might take even longer than expected as price pressures stay stubbornly high. The best savings yields are now topping inflation, but borrowing costs have hit their highest in more than a decade.

Here are the six main ways the Fed’s interest rate decisions impact your money, from your savings and investments, to your buying power and job security.

1. The Fed’s decisions influence where banks and other lenders set interest rates

Higher Fed interest rates translate to more expensive borrowing costs to finance everything from a car and a home to your purchases on a credit card. That’s because key borrowing rate benchmarks that influence some of the most popular loan products — the prime rate and the Secured Overnight Financing Rate, or SOFR — follow the Fed’s moves in lockstep.

When interest rates are higher, the availability of money in the financial system also tends to shrink, another factor making it more expensive to borrow. Sometimes, rates even rise on the mere expectation the Fed is going to hike rates.

Case in point, here’s how much more expensive it’s gotten to finance various big-ticket items this year, after 5.25 percentage points worth of tightening from the Fed:

Borrowers often see higher rates reflected in one to two billing cycles — but only if they have a variable-rate loan. Consumers who locked in a loan with a fixed interest rate won’t feel any impact when the Fed raises rates.

One place where higher rates have been clear: credit cards. Credit card annual percentage rates (APRs) have been among the highest levels ever recorded since the fall of 2022. Those higher interest rates, however, won’t impact you if you pay off your credit card balance in full each month.

“Borrowing costs tend to increase first after a Fed rate hike,” says Liz Ewing, former chief financial officer of Marcus by Goldman Sachs who’s now chief financial officer at Sapient Capital. “Banks are not required to line up their interest rates with the Fed’s rate, so each bank will respond to the Fed’s rate announcement and adjust rates in their own way.”

And while mortgage rates generally follow the Fed, they can often — and quickly — become disjointed. Mortgage rates mainly track the 10-year Treasury yield, which is guided by the same macroeconomic forces. But at its most basic level, those yields rise and fall due to investors’ inflation expectations, along with the public’s appetite for borrowing from the government.

As inflation proves more stubborn so far in 2024, the key 10-year Treasury yield has risen 70 basis points, pushing the 30-year fixed rate mortgage up from a starting position of 6.96 percent to 7.31 percent.

“We need to see meaningful improvement on core inflation and a trajectory toward slower economic growth before we’ll see a substantive pull back in mortgage rates,” McBride says. “We’re not there yet.”

Longer-term yields, and consequently, mortgage rates, might also drop when the Fed is deep in the middle of an asset-purchase plan to lower longer-term rates, effectively making the U.S. central bank the biggest buyer in the marketplace.

2. Higher rates from the Fed also make it harder for borrowers to get approved for new loans

One of the reasons higher interest rates slow demand: They cut off households from the never-ending credit spigot. And as in the aftermath of three major bank failures, lenders may even become stingier about loaning money out — meaning getting approved for a loan could get harder, too.

A March Bankrate poll showed that half of applicants have been denied a loan or financial product since the Fed began raising interest rates two years ago. Americans with credit scores below 670 are finding it toughest to access credit.

The phenomenon reflects one of the key features of a rising rate environment: Lenders sometimes grow pickier about who they lend money to, out of fear that they may not be paid back. Interest rates may climb even faster for borrowers perceived to be riskier. Financial firms may also fear that the risk of default is higher because monthly payments effectively become costlier when interest rates are high.

It also does some of the Fed’s work for it. Consequently, less access to credit leads to less spending — weighing on demand and taking some of the steam away from inflation.

“Tighter credit hits borrowers with less-than-stellar credit ratings the hardest – whether the borrower is a consumer, corporation, municipality or a national government,” McBride says. “The business of lending doesn’t stop but is instead more intensely focused on borrowers posing the least risk of default.”

3. Savings accounts and certificates of deposit (CDs) move in lockstep with the Fed’s rate

You might not be able to borrow as cheaply as you used to, but higher interest rates do have some silver linings, especially for savers. Banks ultimately end up increasing yields to attract more deposits.

The average savings yield is more than seven times higher than it was when the Fed first started raising rates, rising from 0.08 percent to 0.57 percent as of April 22, the highest since March 2007, according to national Bankrate data.

Meanwhile, a 5-year certificate of deposit (CD) was paying 0.39 percent at the beginning of January 2022, before the Fed began raising rates. Today, it’s offering an average yield of 1.42 percent.

But there are banks offering even more money in interest. Finding them could help consumers preserve some of their purchasing power — and even beat inflation. Those yields are at online banks, which are able to offer more competitive interest rates because they don’t have to fund the overhead costs that depository institutions with physical branches have.

A big example: The highest-yielding online savings account was offering an annual percentage yield (APY) of 0.55 percent at the beginning of 2022. Today, it’s offering 5.55 percent.

“Retail savings rates often move a bit slower in a rising rate environment, but can also fall slower in a declining-rate environment,” Ewing says. “Customers who have high-yield savings products could be getting good value in the long run.”

Yields, however, are beginning to edge lower on the expectation that the Fed will eventually be able to cut interest rates this year. The top 5-year CD is now paying 4.55 percent, down from 4.85 percent just last October.

“If you’ve had your eye on a CD with a maturity of two to five years, now’s the time to grab it,” McBride says. “CD yields have peaked and have begun to pull back so there is no advantage to waiting if you have the money to deploy right now.”

4. The Fed’s rate decisions influence the stock market — meaning your portfolio or retirement accounts

Cheap borrowing rates often bode well for investments because they incentivize risk-taking among investors trying to compensate for lackluster returns from bonds, fixed income and CDs.

On the other hand, markets have been known to choke on the prospect of higher rates. Part of that is by design: Essentially, the U.S. central bank zaps liquidity from the markets when it raises rates, leading to volatility as investors reshuffle their portfolios.

It’s also because of worries: When rates rise, market participants often become concerned that the Fed could get too aggressive, slowing down growth too much and perhaps tipping the economy into a recession. Those concerns battered stocks in 2022, with the S&P 500 posting the worst performance since 2008 in the year.

But the idea of rate cuts in 2024 stoked a rapid market rally. The S&P 500 has broken 21 record highs so far this year.

Markets, however, have been bumpy lately, as price pressures retreat much more slowly than expected. The key stock index is 3 percent off its previous high, though still up about 7 percent over the course of the year.

That’s why it’s important to keep a long-term mindset, avoiding any knee-jerk reactions and maintaining regular contributions to your retirement accounts. When the Fed raises rates, that’s mostly to make sure the financial system doesn’t derail itself by growing too fast. Not to mention, falling stock prices can create tremendous buying opportunities for Americans hoping to bolster their portfolio of long-term investments.

“Mom-and-pop investors should focus on the bigger picture: An economy that’s growing is conducive to an environment where companies will grow their earnings,” McBride says. “Ultimately, a growing economy and higher corporate earnings are good for stock prices. It just might not be a smooth road between here and there.”

5. The Fed has a major influence on your purchasing power

The Fed’s interest rate decisions are bigger than just influencing the price you pay to borrow money and the amount you’re paid to save. All of those factors have a prevalent influence on your purchasing power as a consumer.

Low interest rates intended to stimulate the economy and juice up the job market can fuel demand so much that supply can’t keep up — exactly what happened in the aftermath of the coronavirus pandemic. All of that can lead to inflation.

Higher Fed interest rates are the main way to weigh on those price increases, but consumers won’t immediately feel an impact. The Fed can’t drill for oil or produce more food; all it can do is weigh on demand so much that it balances back out with supply, leading to a lower pace of price increases. Research suggests it takes a full year, if not longer, for one rate hike to make its way through the entire economy.

“Inflation is easing but has further to go to get to the 2 percent level,” McBride says. “Robust consumer demand and continued strength in the labor market could lead to inflation moving back up, or at least not moving lower as consistently as we’ve seen in recent months.”

Inflation has noticeably improved since surging to a 40-year high of 9.1 percent in June 2022. Yet, overall inflation rose 3.5 percent in March, still 1.5 percentage point above the Fed’s 2 percent goalpost. Prices are up a higher 3.8 percent when excluding those more volatile food and energy costs, according to the Department of Labor’s consumer price index (CPI). The largest group of economists (60 percent) in Bankrate’s fourth-quarter Economic Indicator poll say prices are at risk of holding above the level that the Fed considers optimal until at least 2025.

Fed officials, however, don’t target CPI. Instead, they prefer to look at the personal consumption expenditures, or PCE, index from the Department of Commerce. That gauge is showing faster improvement, though still indicating that inflation is in a holding pattern, with overall prices rising a slower 2.7 percent in December from a year ago. Prices when excluding volatile food and energy costs rose 2.8 percent over the same 12-month period.

6. The Fed influences how secure you feel in your job or how easy it is to find a job

One of the biggest corners of the economy impacted by higher interest rates is the job market. Expansions that seemed wise when money was cheap might be put on the backburner. New opportunities made possible by low interest rates are no longer on the table.

That has implications for more than just businesses. Workers seeing new opportunities vanish might start to feel jittery about job-hopping.

All of those moving parts are becoming more apparent now. Job openings are still higher than at any time before the pandemic, though as of February, they’ve dipped to 8.8 million from a record high of 12 million in March 2022, Labor Department data shows. Job creation has also slowed from its burst in 2021 and 2022, though employers in March added a healthy 404,000 new jobs, while the unemployment rate held at a historically low level of 3.8 percent — showing the job market is holding on strong.

Some industries have been tougher for jobseekers than others. Big tech firms including Meta, Amazon and Lyft laid off thousands of workers since the Fed started raising rates. Data from outplacement firm Challenger, Gray & Christmas shows job cuts nearly doubled in 2023 compared with 2022, hitting the highest total since 2009 when excluding pandemic-related layoffs.

Layoffs aren’t widespread in data from the Labor Department, and they’re continuing to hold near record lows. The question, however, is how long that could last. Even though the job market is still chugging along, economists in Bankrate’s quarterly poll see joblessness rising from its current 3.7 percent level to 4.2 percent by March 2024. Employers are projected to create half as many jobs over the next 12 months.

Revealing just how interconnected the economy is, sometimes a booming labor market can also contribute to inflation. When there’s a mismatch between labor demand and supply, companies often boost wages to recruit more workers.

How much tight labor markets are currently contributing to inflation is also up for debate. Research from the San Francisco Fed suggests higher wages have only contributed 0.1 percentage point to the growth to the Department of Commerce’s measure of inflation, excluding food and energy. Companies have been able to eat the higher cost of labor or make savings down the line with increased automation or efficiency, economist Adam Shapiro suggested in the research.

Bottom line

Raising interest rates is a blunt instrument with no method of fine-tuning specific corners of the economy. It simply works by slowing demand overall — but the risk is that the U.S. central bank could do too much. Put in the mix that officials are trying to judge how rates impact the economy with backward-looking data, and the picture looks even darker.

While the odds of a soft-landing look promising, eight of the Fed’s past nine tightening cycles have ended in a recession, according to an analysis from Roberto Perli, head of global policy at Piper Sandler.

A higher-rate environment makes prudent financial steps all the more important, especially having ample cash you can turn to in an emergency.

Boosting your credit score and paying off high-cost debt can also create more breathing room in your budget in a higher-rate environment. Use Bankrate’s tools to find the best auto loan or mortgage for you, and shop for the best savings account to park your cash.

“You need an emergency fund regardless of where interest rates and inflation are,” McBride says. “You can’t afford to take risks with that money. That’ll stabilize your financial foundation, in the event that tougher economic days lie ahead.”