What actually happens once the Fed announces an interest rate cut

People on Wall Street, in C-suites and around the kitchen table are on tenterhooks today, waiting for the outcome of the Federal Reserve’s Open Market Committee meeting on Tuesday and Wednesday. The central bank is all but certain to start cutting interest rates, and now, the only real question is: How much? A quarter percentage point? A half?

We will learn for sure during the Fed’s press conference on Wednesday. But rates don’t magically change just because a Fed official announces they’ve changed. Wednesday’s announcement is only the start of the process, because there are a whole bunch of things the central bank has to do to actually bring rates down throughout the economy. 

Seth Carpenter, Morgan Stanley’s Global Chief Economist, spent 15 years at the Federal Reserve, spending a lot of time on the actual implementation of monetary policy. He said the Federal Reserve’s Open Market Committee starts the process by coming up with a target of where they want interest rates to be.

“Then, it’s up to the staff to make sure the market rate trades as close as possible to the committee’s target rate,” Carpenter said.

Interest rates are really just prices: the price of borrowing money. And when the Fed wants to bring down that price — like it does now — it cuts the amount of interest that it pays to banks on reserves the banks deposit with the Fed.

“Literally, there’s a computer application where someone is able to explicitly input what the interest rate is paid on reserves,” Carpenter said.

That rate is a floor: the cheapest lending in the whole economy, available exclusively to banks, which themselves are in the business of lending.

“If the Fed is going to pay you a certain amount, there’s no reason for you to lend in the market at a rate below that amount,” Carpenter said.

Banks also know their interest rates can’t go too much higher than what the Fed is paying. That’s because there are lots of banks and other lenders competing for customers who want to borrow.

Dominik Mjartan, vice chairman of Optus Bank in South Carolina, said if a bank wanted to charge way more than what the Fed is paying — 10%, for instance — it might watch all of its customers head across the street to its competitor.

“If a competitor bank across the street or across the country is now charging 7%, you want to be competitive — you’re going to have to bring that cost down as well,” Mjartan said.

When the Federal Reserve lowers interest rates, bank customers start asking why they’re still paying so much for the money they’ve borrowed.

“So they’re going to come and anticipate, ‘Well, the Fed just lowered the rate, so shouldn’t I get a lower rate?’” Carpenter said.

Once the Federal Reserve announces it’s cutting interest rates, the effect doesn’t ripple out evenly. Different types of loans take different amounts of time to adjust, according to Nathan Rogge, CEO of First Pacific Bank in Southern California.

“As an example, in my world, because we do a lot of small business loans, those can adjust monthly, or quarterly, or even annually,” Rogge said.

Rogge said auto and commercial real estate loans aren’t as directly tied to the Fed’s moves, so they can take a little longer to change. New mortgages, on the other hand, have already been falling ahead of this week’s Fed meeting. That means they might not fall immediately after a Wednesday rate cut.

“They could technically go up the day that the Fed announces,” Rogge said.

But there are plenty of loans that will drop as soon as the Fed lowers rates; that includes the interest on credit card debt and home equity lines of credit. 

“It normally happens the next day,” Rogge said. “So if it was a Wednesday, by Thursday, you would have a different interest rate.”

And as banks start earning less on the loans they make, it probably won’t take long before they start paying depositors less interest too.