The Federal Reserve, Interest Rates & the Impact Upon You
istory tells us that the role of the United States Federal Reserve is to create a stable monetary environment. Its role is categorized by having a dual-mandate under Monetary Policy:
- Maintaining Maximum Levels of Employment
- Maintaining Stable Prices & Long-Term Interest Rates
So why is this entity so important? Well, because its actions are critical to a stable economy and that fact is demonstrated by the strategic levers it can pull to provide stability in times of crisis and brakes when the economy is overheating.
Right now, given market volatility and uncertainty surrounding Coronavirus, global trade tension, bank liquidity issues and lending, etc. it may help to understand how Fed decisions affect you – the consumer – as well as businesses and trade.
Let’s focus on prong #2 – Price Stability & Interest Rates – which are undoubtedly Fed powers that are utilized most regularly and can quickly facilitate the most immediate change:
Interest Rates: The Fed has the power to reduce or lower interest rates in order to influence our economy if we are in an expansionary or contracting mode. As of late, the Fed has been steadily lowering interest rates. In general, the hope is that such actions will spur economic growth and borrowing activity as well. Most recently, in 2009, rates were brought to their lowest level in history – near zero – to remedy the financial crisis. Right now, we are hovering around the same levels as we combat uncertainty related to Coronavirus, trade, and a now suddenly upended economic recovery.
As an investor, fixed income instruments and bank certificates of deposit are not paying as much as they used to. Theoretically, the hope is that investors will turn to equity markets in search of yield and higher returns. Low rates also make it less expensive for businesses to fund operations. Of course, every situation and period of volatility has its unique characteristics and what we are currently experiencing is no different. Often times, during periods of unease, government intervention does not play out as it may have in the past. Time will tell how this chapter of Fed intervention will support our financial system. We believe it is important that the Fed take necessary steps to stabilize our economy. But, often times, investor sentiment and nervousness cannot be controlled. And we are seeing this reality play out in live time.
To be clear, for consumers, there are certain natural benefits of low interest rates. For instance, homeowners can build additions via low interest lending options, while renters can consider a home purchase through a low interest mortgage. This environment also supports business spending and how corporations use their capital to reinvest in their own business. When businesses can borrow at a low rate, this allows them to utilize cash flow for other purposes like salary increases, hiring, dividend increases to shareholders, etc. Low rates can benefit consumers and businesses alike. The flipside is corporations that are in the business of lending prefer higher rates. The margin on what they charge, versus what money costs them, is in part how they make money. So, as rates eventually start to tick up, albeit slowly, we may start seeing banking institutions benefit from this change.
Now let’s consider the economy as a whole. Low interest rates are a reflection of an economic backdrop and cycle. In 2009, when rates were dropped to near zero, this decision was made because our banking system needed intervention to support recovery. That is not the case today. Rates are being kept within a range that indicates that the Federal Reserve believes our economy is not “overheating” or in a “late-cycle” which would signal a pullback, but is experiencing high levels of volatility that requires support.
Another lever of the Fed’s Monetary Policy is…
The Federal Open Market Committee (FOMC): This policymaking body is responsible for the flow of money into or out of our financial system through the buying and selling of government securities. The Fed can add money into our banking system by buying assets and in turn, banks can then lend money out, thus supporting availability of funds between banks and customers. This activity is known as quantitative easing. The Fed can also require banks to purchase government securities to reduce money supply if the economy is growing too quickly.
The Fed’s third option is to influence…
Reserve Requirements: This term refers to assets that banks are required to maintain in order to meet their liabilities or potential losses. By lowering this capital requirement, the Fed is enabling banks to lend more easily and release more funds into the system. Conversely, increasing reserve requirements tightens their belt and restricts the flow of money, supporting an economy from overheating.
So, one of the things that the public can take comfort in is knowing that through a combination of strategic options, the Fed is monitoring employment, the economy and also looking at stability of prices. It can give the economy a push through various means in tough times. Or, if it is getting ahead of itself, it can turn down the temperature and set the economic pot to simmer. And that is really what its job is – to keep us in a position to remain healthy and make sure the economy doesn’t cool off or boil over.
As advisers, we believe it is important to equip ourselves with knowledge to make informed decisions and provide thorough guidance during times of uncertainty as well as euphoria. It is our hope that this summary on the Federal Reserve’s role provides some insight into their actions as well as potential market and investor reactions to such activity.
As always, do not hesitate to reach out if you have any questions about your situation or would like to discuss markets in general. We hope this commentary has helped add to your knowledge and understanding of how markets, economies and Federal Reserve policy are interconnected.