Understanding the impact of the Federal Reserve on retirement savings

Why the Fed and its policies matter to a plan sponsor

Interest rates can play a big role in the outcomes of retirement savings and may have a direct impact on accounts that earn interest. They also affect the stock market. When interest rates are rising, borrowing is more expensive, which means consumers and businesses tend to spend less. This often causes earnings to fall and stock prices to drop. And when interest rates fall, consumers and businesses generally increase spending, which causes stock prices to rise. 

As a retirement plan sponsor, you want to consider offering your participants access to a diversified menu of investment options. By understanding how the Fed uses interest rates to stabilize the economy, plan sponsors can likely provide more informed, holistic investment guidance to participants. 

What is the Fed?

The Federal Reserve System is the central bank and monetary authority of the United States, performing five key functions:

• Develop and implement monetary policy to maximize employment and maintain stable prices 
• Promote the stability of the financial system 
• Ensure the safety and soundness of financial institutions
• Foster a safe and efficient payment and settlement system 
• Promote consumer protection and community development

The Federal Reserve System is made up of three primary components: 

• Board of Governors—The board oversees the Federal Reserve System and operates as an independent government agency. It has seven members who are nominated by the President and confirmed by the Senate.
• Federal Reserve Banks—Twelve regional Federal Reserve Banks carry out the system’s day-to-day operations, and each has a president.
• Federal Open Market Committee (FOMC)—The FOMC typically meets eight times a year to discuss monetary policy options. The committee has 12 voting members, including all 7 members of the Board of Governors, and a rotating group of five Federal Reserve Bank presidents.

The Fed has governed the United States monetary and financial system for more than 110 years. Important dates in its history include:

• Founded in 1913—Throughout the 19th century, there was a series of disruptive banking panics in the United States, followed by a catastrophic worldwide financial crisis that resulted from the Panic of 1907. President Woodrow Wilson passed the Federal Reserve Act in 1913, establishing the Federal Reserve System as the central bank.
• Amended in 1977—The Federal Reserve Act was amended to promote the goals of maximum employment, stable prices, and moderate long-term interest rates. The central goal became to engage in macroeconomic policy that simultaneously maximizes employment and maintains price stability. This central mission is known as the Fed’s dual mandate.

The Fed’s monetary policy decision-making process

Achieving the Fed’s dual mandate of creating jobs and keeping prices steady isn’t simple. The Fed can’t just create jobs or change prices—they use monetary policy to encourage businesses to take action. Although the Fed’s policies work indirectly and can be influenced by many other economic matters, they’re far reaching and variable. These policies, however, may only have their intended effect long after being implemented.

One way the Fed tries to influence the economy is by adjusting the Federal Funds rate. This is the overnight interest rate that financial institutions charge each other to lend money, and it’s the basis of all the interest rates they charge (or pay) consumers and businesses.

The Fed’s monetary policy can go two ways:

• Contractionary policy—When inflation is high, the Fed wants to slow down or contract the economy to bring prices down. To do so, they may raise the Federal Funds rate to tighten the money supply and control inflation. Why? When money costs more to borrow, people and businesses tend to reduce spending, which should help bring prices down. 
• Expansionary policy—When they want to expand the economy, such as during a recession, the Fed lowers the Federal Funds rate to release more money into the economy. Why? By making borrowing cheaper, they hope that people and businesses start spending more. 

Comparison of inflation rate, unemployment rate, federal funds effective rate, and U.S. recessions

U.S. Bureau of Economic Analysis, Personal Consumption Expenditures (PCE) Excluding Food and Energy (Chain-Type Price Index), retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DPCCRV1Q225SBEA, 7/22/24. U.S. Bureau of Labor Statistics, Unemployment Rate (UNRATE), retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org /series/UNRATE, 7/22/24. Board of Governors of the Federal Reserve System (U.S.), Federal Funds Effective Rate (FEDFUNDS), retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FEDFUNDS, 7/22/24.

While the general rules explained above are simplified, the information above demonstrates that they’re fairly reliable. In times of economic overheating or persistent, high inflation, the Fed raises interest rates. In times of economic contraction or recession, the Fed lowers interest rates.

What do retirement plan participants need to know about the Fed?

When the economy is doing well, retirement plan sponsors and participants might feel like they don’t need to keep up with the Fed’s meetings and decisions. But when the Fed is actively working to influence change in the economy by raising or lowering interest rates—as they almost always are doing—participants should be made aware of what’s happening. They should understand how the Fed’s decisions may affect different aspects of retirement planning such as the prices they pay for goods and services, the interest they may pay on loans or earn on deposits, and the value of stock market and retirement investments. As a plan sponsor, it’s crucial to be aware of our everchanging economic conditions and keep up with the Fed in times of turmoil. This allows you to better understand how the Fed’s monetary policy, specifically interest-rate policies, might affect retirement for your participants. With the help of your plan’s financial professional and recordkeeper, you can educate participants and provide help on how to keep their savings on track.