Who is the Fed?

The Federal Reserve, or The Fed, is the central bank of the United States governed by board members who are currently chaired by Jerome Powell. One of the primary functions of the Federal Reserve is directing the country’s monetary policy. Simply put, monetary policy is the management of how many people have jobs, the cost of goods and services (inflation), and you guessed it, interest rates! Interest rates are what we’re talking about in this article. In theory, by leveraging each of these monetary policy elements, the government has some control over the economy.

www.federalreserve.gov

Why Interest Rates Are Important

Interest rates determine the cost of borrowing and the amount you earn on cash you save. Interest rates give us a good idea of the value of cash at a point in time and the general risk of the financial and economic environment.

When rates are high, consumers who are buying a house, car, or racking up credit card balances are paying more for not making their purchases in cash. However, they are earning a higher amount on banking deposits. In other words, cash is relatively valuable. Conversely, banks are making more from lending money because they are charging higher rates but are also paying more interest on client deposits.

When rates are high, the general thought is that U.S. consumers and businesses prefer to hold their cash, not borrow money, and decrease spending. The cost of spending is high as consumers are foregoing the opportunity cost of earning interest on bank deposits and are paying more to borrow.

When rates are low, consumers aren’t as worried about losing out on interest earned on bank deposits and are more willing to make big purchases because they cost less to finance. Business spending also increases due to the same logic.

By controlling interest rates, the Federal Reserve can theoretically influence spending by consumers and business. And theoretically, spending grows the economy. When the economy is slow and the Fed would like to increase growth, they decrease rates to increase spending. They implement expansionary monetary policies. When the economy is overheated, inflation is high, and they would like to taper growth, they increase interest rates to decrease spending. This is called contractionary monetary policy.

How The Fed Raise & Lower Rates

The answer to this is short, they raise and lower rates by announcing the decision to do so. But keep in mind as a consuming borrower or saver, you may not see these decisions immediately impact the interest you are receiving on your bank account or the mortgage you just applied for.

The Federal Reserve does not set mortgage, credit card, or interest-bearing account rates. The Fed sets the federal funds rate which banks and financial institutions lend and borrow money from each other on single-day, overnight transactions. As you can imagine, since this rate applies to such short-term and high-quality borrowing, it tends to be low. Decisions to increase or decrease rates typically occur in ¼ of 1% increments, .25%, or 25 basis points (bps).

Why is this micro-term borrowing even necessary, you ask? Because as part of banking regulations, banks are always required to keep a certain percentage of total deposits liquid (available for redemption). Because banks transact daily, their deposit balances will fluctuate. Banks are a business too and make money from investing consumer deposits in higher paying, longer term investment opportunities. While banks could be conservative and keep a large liquid buffer amount at all times, they are forgoing returns on investing deposits. It is more business savvy to pay a small rate to borrow funds to meet mandated liquidity.

So how does this roll up to the consuming public? Federal funds rates are a base rate that serves as a benchmark for items such as mortgages, credit cards, and savings accounts, ultimately impacting what we pay and earn in interest.

What Investors Need To Watch

This year, the Federal Reserve has decided to cut rates three times by 25 bps each. Starting the year at 2.5%, the current rate is 1.75%. So, what does this mean to the individual investor?

Typically, expansionary monetary policy means value & defensive stocks are in favor. Think sectors such as utilities, consumer staples, and industrials. Decreases in rates also mean that the price of bonds will increase. And lastly, your money market and short-term deposit accounts will likely not pay as much interest.

The exact opposite affects should happen when rates increase leading to favor in growth stocks like tech & consumer discretion, decrease in bond prices, and increased rates of short-term interest-bearing deposits.

Changes in the Federal Fund rate tends to be a lagging indicator, meaning it is a response to what has already occurred in the economy. Do not look to rate hike and cut decisions as a crystal ball for investment decisions. Observing the yield curve might be a better future indicator of what types of stocks may be in favor in the future.

Lastly, keep in mind the Fed only has control over our country’s monetary policy, limiting them to influencing the economy by changing interest rates. Fiscal policy covers the government’s efforts to achieve the same influence by controlling taxes and federal spending. Let’s leave that topic for another day….