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Video: Why Did The Fed Drop Interest Rates?

We explain how interest rates work and why the Federal Reserve keeps lowering them during the COVID-19 pandemic.

Articles by Dan Egan
By Dan Egan Managing Director of Behavioral Finance & Investing, Betterment Published May. 06, 2020
Published May. 06, 2020
3 min read

If you’re looking for more guidance, we’ve got you covered with our guide to stock market volatility.

Transcript

“One of the questions we’ve been getting a lot over the past few weeks is: who exactly is the Federal Reserve and what exactly did they just do?

In order to answer this question, I’m going to start off with a brief explainer about how our banking system works. So, let’s start with Sarah. Sarah has an extra $100, she wants to earn some interest on it, she takes it and she puts it into a bank.

The bank is then going to loan out some of that, say $50 to me, which I’m going to use to buy a house. The other $50 is going to be put into some high-yielding corporate bonds, and other sorts of investments that are safe, and a little bit more liquid than my mortgage.

After about, I don’t know, 6 months—Sarah comes back and says actually, she’d really like $50 of her $100 back. Now, there are regulations about how much collateral banks need on hand to handle it when customers who have made deposits come in and say “actually, I’d like my money back, please.”

A lot of this does come out of experience with bank runs and various problems in history. So we have regulations now that say okay, you have to keep this much capital on hand. The issue is that while the bank has my mortgage and it also has this corporate debt or other safe securities, they’re not able to sell those as easily.

What happens in time of crisis is that the Fed’s going to come in and is going to provide liquidity, which basically means they’re going to take some of those loans, the high-yield corporate debt, or even my mortgage, and say, “actually, we’ll give you cash, and we will use that mortgage or those bonds as collateral.”

Effectively what happens is the Fed loans cash to the bank and the bank is able to give that cash to Sarah, and Sarah goes on with her day. Nobody noticed that the Fed provided liquidity to this system.

There’s a second component to what the Fed’s doing. The first component’s very short-term, it’s about making sure that the payments and the orderly processing of things in the system, like Sarah making a withdrawal from her savings account, goes through smoothly. The second component is more long-term, and it’s about investment.

It’s about encouraging people to not keep cash in savings accounts. Imagine this for a second. Imagine that you had a bank savings account that paid 10% interest with no risk. Why would you take any risk investing in businesses or companies if you could make that high return with no risk in a bank account?

The first part of it is that the Fed really wants to decrease how attractive savings accounts are so that you’re incentivized to go out and invest in businesses. The second component, which is very similar, is that it also wants you to be incentivized to go and spend that money. Get it out and moving around in the economic system.

Maybe somebody else will take it and it will keep their business afloat. Or, they’ll put it into some form of investment like starting a new company or serving other clients. The key part is that we don’t want too much money sitting around in savings accounts because that means it’s not being put to work in the economy into real businesses where jobs and growth actually happen.

By lowering the interest rate, the Fed is making other things, mainly spending and investing, more attractive. So, right now, across the board as the Fed drops rates, you’re going to see interest rates on all accounts across the board drop in lock step.

There are some nice parts to this. If you can go out and refinance your mortgage or your student loan debt, this is a great time to do it.

Thanks, I hope that was helpful. Feel free to ask us any questions if you have any.”

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