how the federal reserve sets rates and why it matters to your portfolio

In short

I once watched a neighbor read a news headline about the Federal Reserve and go pale, as if the weather had just turned on him. If you have ever felt that way, you are in good company, and a little knowledge goes a long way. The Federal Reserve does not set the rate on your savings account or your mortgage directly. It sets a target for the rate banks charge each other for overnight loans, and that target ripples out from there. Your savings yield, your loan costs, and the price of bonds and stocks all feel some of that ripple. The size of the ripple differs from person to person, so look at your own accounts and loans before you worry. Check the rate on each one, write it down, and you will know where you stand.

The whole of it

What it is

A friend of mine once asked me who decides the price of money. I told him it is not one person in one room, though it comes close. The Federal Open Market Committee, a group inside the Federal Reserve System, meets about eight times a year to set a target range for the federal funds rate. That rate is what banks charge one another for very short loans, usually overnight. The Federal Reserve Act gives the Fed two goals, maximum employment and stable prices. You will often hear this called the dual mandate.

Think of the rate as a dial on the wall of a big house. Turn it up, and borrowing costs more all through the house. Turn it down, and borrowing costs less. The Fed turns the dial slowly and tells people why. That openness is part of the plan, because folks make better choices when they are not caught off guard.

How it works

If you are holding a savings account, a car loan, or a mortgage, you have probably wondered how a meeting in Washington reaches your kitchen table. It travels in steps. The committee sets the target range. Banks then adjust what they pay on deposits and charge on loans. Prime rate, which banks use for many credit cards and home equity lines, usually moves right along with the federal funds rate.

The Fed also uses a few other tools. It pays interest on money banks keep at the Fed, and that helps hold the funds rate inside the target range. It can buy or sell government bonds. When it buys, it adds money to the system, and when it sells or lets bonds mature without replacing them, it pulls money back. The Federal Reserve explains all of this on its own website, and the committee posts a statement after every meeting.

Now to your portfolio. A bond pays a fixed amount, so when new bonds pay more, the old ones look less appealing and their prices fall. When rates fall, the reverse happens. A bond that is longer in maturity moves more than a short one. Stocks feel it in a few ways. Higher rates make borrowing dearer for companies. They also make safe options like Treasury bills more attractive next to risky ones. Neither effect is fixed in advance. Prices can move before the Fed acts, because investors try to guess what is coming.

The numbers, and where to find yours

Here is the plain truth. The current target range is not a number I will state from memory, because it changes. The committee posts it after every meeting at federalreserve.gov, and the figure today is the current figure, which the official source publishes each year. The prime rate, which follows closely behind, is the current figure, which the official source publishes each year. The Fed also publishes a yearly inflation goal, which is the current figure, which the official source publishes each year.

Your own numbers matter more than these. Look at the statement for each savings account and find the annual percentage yield. Look at each loan and find the annual percentage rate, and note whether it is fixed or variable. A fixed rate stays put when the Fed moves. A variable rate can change, and the loan paperwork says how often and by how much. The lender must disclose that in the loan agreement, so it is in black and white. For bonds, a fund fact sheet lists a figure called duration, which estimates how much the price moves if rates move one percentage point. If you cannot find it, call the fund company and ask.

A worked example

A woman I will call Dana lives in a small town and keeps things simple. She holds a bond fund worth $40,000. Its fact sheet lists a duration of 6 years. That means a rise of 1 percentage point in rates would cut the fund price by about 6 percent. She works it out on paper. 6 percent of $40,000 is $2,400. So a 1 point rise in rates might lower her fund by about $2,400 in price, all else equal.

Dana also has a variable rate loan of $10,000. Say its rate rises from 7 percent to 8 percent. At 7 percent, a year of interest is $10,000 times 0.07, or $700. At 8 percent, it is $10,000 times 0.08, or $800. The loan costs her $100 more a year. That is real money, though not a crisis.

Now the good side. Dana has $15,000 in a savings account. If the yield rises from 4 percent to 5 percent, a year of interest goes from $15,000 times 0.04, which is $600, to $15,000 times 0.05, which is $750. She earns $150 more a year. So the same rate move cost her $100 on the loan and paid her $150 on savings. It did hit her bond fund price by about $2,400 on paper, but that is a price change, not cash out of her pocket, unless she sells.

Dana did not need a degree to see this. She needed a pencil and her own statements. Her bond fund pays interest too, and a higher rate means new money earns more. Over a long time, that can offset part of the price drop. The fact sheet and the fund company can show her how.

Where it goes wrong

I have made this mistake myself, so I say it kindly. It is easy to treat a Fed decision as a prediction of what markets will do next. It is not. Prices often move on the guess, long before the vote. By the time the news lands, much of it may already be baked in.

Another trap is thinking one rate rules them all. Mortgage rates track longer term Treasury yields more than the federal funds rate. So a mortgage rate can move even when the Fed holds still. Credit card rates follow prime more closely. Each product has its own link, and the loan agreement spells it out.

A third trap is forgetting that the Fed can be wrong. Its own forecasts get revised. It gets criticized, and it admits mistakes in its published minutes. Treat its projections as a best guess, not a promise. Past moves also do not tell you what the next one will be.

Last, watch out for after tax math. Interest on savings is taxed as income, so a higher yield can mean a larger tax bill. A $750 yield may leave you less than $750 after tax, depending on your bracket. The IRS explains how interest is taxed on its website. Plan for it.

Questions to answer before you leave this page

Do you know the rate on every savings account you hold, and whether it moves when the Fed moves? Have you looked at each loan to see if the rate is fixed or variable, and what the lender says about changes? If you own a bond fund, have you found its duration on the fact sheet and worked out what a 1 point rise would do to its price? Can you say, in one sentence, why the Fed moves the dial, and what its two goals are? Have you thought about which of your accounts gain when rates rise and which ones lose? And when the next headline comes along, will you reach for your own statements first, rather than reaching for worry?