Mellody Hobson: Fed Rates and Your Finances
Dec. 15, 2004 -- -- The Federal Reserve has raised the key short-term interest rate by one-quarter percentage point to 2.25 percent. This was the Fed's fifth increase this year and a sign that it is likely to continue on this path in 2005.
Why did the Fed raise rates?
The Fed likely acted in response to new reports of the economy's increasing strength. The United States economy grew at an annual rate of 3.9 percent from July to September. Additionally, the price of oil has stabilized (down from $55 a barrel in October to $41) and jobs continue to be added to the payroll (112,000 in November alone). Fed Chairman Alan Greenspan has long been a proponent of incremental and measured adjustments to the fed funds rate as a means of preventing inflation and sustaining economic growth. That said, the impact of this increase will be felt across many financial spectrums. For the consumer, you will feel its effects most in the following areas:
• Your mortgages and car loans: Mortgage rates follow the yields of various U.S. Treasuries and other indexes, which usually price in anticipated rate increases by the Fed. As such, mortgage rates have already begun to rise. The shorter the term of your loan, such as those with short-term adjustable rates, the more quickly your interest rate will be affected. Interest rates on car loans are linked to movement in the yields on the 2-year Treasury, which has also already priced in the anticipated federal funds rate hike. So those looking to buy a new car may have already seen increases in car loan interest rates. However, if you already have a car loan, no need to worry as your rate is fixed.
• Your credit cards: Credit card users will be impacted by a Fed rate increase. However, when you will actually see the interest rate change on your credit card statement depends on when it is re-priced -- some re-price each quarter while others re-price each month. If you have a fixed-rate credit card, you are not necessarily insulated from rate fluctuations. In fact, issuers can change rates or change the card to a variable-rate with as little as 15 days' notice.
• The economy: Given that a good economy is a "rising tide" for all economic boats, the Federal Reserve System has said it will raise the federal funds rate at a "measured" pace. While many consumers may be panicking at the possibility of these interest rate increases, the impact of higher rates may be muted because rates are starting from such a low point. Longer term, interest rates are forecast to increase 3.75 percent by year-end 2005.
Changes in interest rates can affect the overall economy with higher interest rates being considered "bearish," while lower interest rates are "bullish." Essentially, higher interest rates tend to slow economic activity as they raise borrowing costs for consumers and businesses, while lower interest rates stimulate economic activity. Either way, interest rates influence the sales environment. In the consumer sector, the rate at which homes or cars are purchased tends to slow as interest rates rise. For businesses, particularly those with high debt loads or those that have to finance high inventory levels, interest rates are a significant factor as the interest cost has a direct impact on corporate profits.
Mellody Hobson, president of Ariel Capital Management (arielmutualfunds.com) in Chicago, is "Good Morning America's" personal finance expert. Ariel associates Matthew Yale and Aimee Daley contributed to this report.
