An interest rate cut is a decision by a central bank to lower the target for its key short-term interest rate. In the United States that is the Federal Reserve lowering its target for the federal funds rate. The Federal Reserve cuts rates when it wants to make credit cheaper and more available, typically to support an economy that is slowing, at risk of recession, or running below its employment and inflation goals. This page is about the directional event, a cut, and what it does to households; the rate itself and the machinery behind it are covered on the federal funds rate and monetary policy pages.
Interest Rate Cuts
An interest rate cut is a reduction in the central bank's target for its benchmark short-term rate, made to make borrowing cheaper and support a slowing economy. Its effects reach almost every loan and savings account you hold.
Last reviewed by Steven Fox, CFP®, EA
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Quick Summary
- A rate cut is the Federal Reserve lowering its benchmark rate target, usually to stimulate a weak or slowing economy.
- Borrowing gets cheaper, so rates on credit cards, home equity lines, and new variable loans tend to fall.
- Savers earn less, as yields on savings accounts, money market funds, and new certificates of deposit tend to drift down.
- Prices of existing bonds generally rise when rates fall, because their older, higher fixed payments become more valuable.
- Cuts are the opposite of interest rate hikes; the two events push borrowing costs and savings yields in opposite directions.
Definition
Advanced Explanation
A rate cut is not a change to one obscure interbank rate in isolation. The Federal Reserve's benchmark sits at the base of the whole structure of borrowing costs, so lowering it pulls down the rates that ordinary people actually pay and earn, though not all at the same speed. Variable-rate products move fastest, because many are priced directly off the prime rate, which tracks the Federal Reserve's target closely. When the target falls, the prime rate falls with it, and rates on most credit cards and home equity lines of credit follow within a billing cycle or two.
The effect on savers is the mirror of the effect on borrowers, and it is the reason a rate cut is not simply good news for everyone. The same drop that makes a new mortgage or car loan cheaper also pushes down the yield on savings accounts, money market funds, and newly issued certificates of deposit. A household that carries variable-rate debt benefits; a household living on interest from safe savings loses. Longer-term fixed rates, such as those on a new 30-year mortgage, are influenced by rate cuts but are set more by the bond market's expectations about the future than by any single move, so they do not track cuts one-for-one.
Rate cuts also move the value of bonds already outstanding. A bond pays a fixed stream of interest, so when newly issued bonds start paying less, the older bonds locked in at higher payments become more attractive and their market prices rise. That inverse relationship between rates and bond prices is a standard feature of fixed income and part of why a falling-rate environment tends to lift existing bond holdings even as it lowers what new savings earn.
Why the Federal Reserve cuts matters as much as the mechanics. Cuts are a tool of expansionary monetary policy, used when the economy needs support, so a string of cuts often signals that policymakers see weakness ahead. Because the effects arrive with a lag, the Federal Reserve usually acts before the slowdown is fully visible in the data.
Used in a Sentence
“After several interest rate cuts, Priya noticed the rate on her home equity line of credit dropped within two statements, while the yield on her online savings account quietly fell over the same months.”
How It Works
The Federal Reserve announces a lower target for its benchmark rate, usually in increments such as a quarter of a percentage point, and uses its tools to bring the market rate down to the new target. From there the change transmits outward to consumer rates, quickly for products tied to the prime rate and more gradually for others.
A hypothetical shows the two-sided effect. Suppose Marcus carries a $10,000 balance on a variable-rate credit card and also keeps $50,000 in a high-yield savings account. The Federal Reserve cuts its target by one percentage point over the course of a year, and the prime rate falls by the same amount. His card rate, tied to prime, drops by about one percentage point, cutting the interest on his balance by roughly $100 a year. But his savings rate also falls by about a point, reducing his interest income by about $500 a year. The single event helped him as a borrower and hurt him as a saver, and which effect dominated depended on the size of each balance.
Pros and Cons
Who tends to benefit from a rate cut
- Borrowers with variable-rate debt (credit cards, home equity lines) see lower rates, often within a cycle or two.
- People taking out new loans face cheaper financing than before the cut.
- Holders of existing bonds generally see the market value of those bonds rise.
Who tends to lose, and the caveats
- Savers earn less on savings accounts, money market funds, and new certificates of deposit.
- A series of cuts often signals that the central bank expects economic weakness, which is not itself good news.
- Long-term fixed rates, such as a new 30-year mortgage, are driven by market expectations and may not fall as much as the cut, or at all.
People Also Asked
Answers to the most frequently asked questions.
Why does the Federal Reserve cut interest rates?
The Federal Reserve cuts rates to make borrowing cheaper and encourage spending and investment when the economy is slowing, unemployment is rising, or growth is running below its goals. Lower rates are a tool of expansionary monetary policy, meant to pull economic activity forward. Because rate changes work with a lag, the Federal Reserve often cuts before a slowdown is fully visible in the data.
Do interest rate cuts lower my mortgage rate?
It depends on the loan. Rates tied to the prime rate, such as most home equity lines of credit and variable-rate loans, tend to fall soon after a cut. A new fixed-rate mortgage is set mainly by the bond market's expectations about future rates rather than by a single move, so it may fall less than the cut or not move much at all. An existing fixed-rate mortgage does not change, though a cut may create an opportunity to refinance.
How do rate cuts affect my savings?
They generally reduce what you earn. Yields on savings accounts, money market funds, and newly issued certificates of deposit tend to drift down after the central bank cuts, because banks no longer need to pay as much to attract deposits. A rate that helps borrowers therefore works against savers, which is why a cut is not simply good or bad for everyone.
What happens to bond prices when rates are cut?
Prices of existing bonds generally rise when interest rates fall. Because a bond's interest payments are fixed, older bonds paying higher rates become more valuable once newly issued bonds pay less, so their market prices go up. This inverse relationship between rates and bond prices is a basic feature of fixed-income investing.
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