Have you ever been listening to the news or reading an article in which the Fed is mentioned and wondered what the heck they’re talking about? Considering how often the talking heads on the news mention the Fed, it’s amazing how little people actually know about it. So, today I am going to shed a little light on who the Fed is, what their goals and tools are and what we see them doing right now.
First and foremost, the Federal Reserve System is the central banking system of the United States. It is most commonly referred to as the Fed. After a series of financial panics, the Federal Reserve was created in 1913 (federalreserve.gov). Although we often talk about the Federal Reserve as a single entity, there are actually twelve Federal Reserve Districts that operate under the one U.S. Central Bank. A gentleman by the name of Jerome Powell is the current Fed Chair along with four other board members. The Fed operates under what is called a dual mandate. This dual mandate is to “promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates” (Federal Reserve Bank of Richmond).
So, what does the Fed actually does? Essentially, the Fed’s job is to keep inflation down and promote maximum employment. They do so with a couple different tools. The first tool in their toolbelt is the Federal Funds Rate. The Federal Funds Rate is the interest rate at which banks lend to one another in order to meet their overnight reserve requirements. Banks are required to have a certain amount of cash on hand every night, if they are below that amount, they can borrow what is needed at the Federal Funds Rate. This is the interest rate you’ve been hearing in the news lately. Put simply, it is the shortest of all the interest rates. They have the ability to move this rate up or down depending on what they deem necessary. In theory (and often times in practice) a rise or decline in these ultra-short interest rates will eventually trickle down to the longer rates such as the 10-year and 30-year. Hence, the third piece of the mandate: moderate long-term interest rates. Interest rates are very low right now. If you’re a saver, you know this because your savings account is getting you less than a percent and if you happen to own a CD it certainly isn’t yielding the double-digits they were 25 years ago. If you’re a spender you might be noticing it as well. Heard anyone mention it being a great time to buy a home? That’s because rates are low (This is not a suggestion to buy a home right now, just for full disclosure). Rates have been low since the 2008 recession. When an economy goes into recession, one way to help bolster economic expansion is to make money cheap. Allowing individuals and businesses to borrow money at very low interest rates encourages them to do so and thus that money is pumped back into the economy through consumer and corporate spending. As consumers spend more the demand for labor increases thus checking the maximum employment box. Ta-da, problem solved! Anyways, when our economy went into recession in 2008, the Fed stepped in and dropped interest rates. Aaaaand they never really came back up again. In the Fed’s defense, this has been one of the slowest economic expansions in history (JPMorgan Guide to the Market). So, in 2017(ish) the Fed decided it was time to more aggressively start raising rates back up. And they did so, until late last year, when they decided to drop them again.
That is where our concerns come in. A very clever way it was explained to me is this: consider every .25% interest to be a bullet (they tend to move in quarter points). Although most of the analysts we follow do not feel we have a recession on the near horizon, we know we will eventually enter recessionary territory at which point the Fed will need (need is a loose term, but that’s for another day) to use what bullets they have to kickstart the economy again. If they only have 7 bullets (current rate is 1.75%), that doesn’t leave them a lot of room to drop rates. The question is, will they have the ability to make money cheap enough to encourage consumer and corporate spending?
That leads me to their second tool, Quantitative Easing. The Fed uses quantitative easing in order to keep a handle on the free flow of money in our economy. Too much money flowing in the economy can create inflation (an increase in overall prices), not enough can create deflation (a decrease in overall prices) and illiquidity. As their mandate states, they are to promote stable prices. The Central Bank buys up a predetermined amount of financial assets in order to inject more money into the economy, creating liquidity. When the Fed doesn’t have enough wiggle room in interest rates, they have the ability to turn to quantitative easing as a way to pump money into the economy. This tool was also used in 2008. On the flip side, the Fed can also tighten by reducing its balance sheet. Rather than continuing to buy assets, they instead sell off assets (or at least stop reinvesting).
In the past 5 months or so, the Federal Reserve Bank of New York (one of those district banks I mentioned previously) has been buying up financial assets in order to create liquidity in the overnight lending markets. Pause for a second; that last sentence just tied in both of the concepts we’ve been talking about, so feel free to read it again. And as we previously discussed, quantitative easing pumps more money into the economy thus adding fuel to a fire that was already burning steadily. Our concern here is the sustainability of it. At what point does this easing come to a head and create too much liquidity in the market thus pushing the stock market to overvalued prices and fueling inflation?
As you can see, when the Fed makes a move, their actions are not without consequences, both positive and negative. Throughout history, we can trace both booms and busts back to action taken by the Fed. Every time the Fed moves a lever there is potential fallout. It’s the fallout, the unintended consequences, that we are concerned with. That is what we watch and prepare our clients for. So, if you hung on through this entire post, kudos to you! I hope it was valuable for you. It is merely a 30,000-foot view on the Fed and there are so many more details that could be discussed, but for today, I’ll leave it here. If you have any more questions, shoot me an email. Ed and I probably enjoy talking about things such as this a little too much.
Opinions expressed are those of Molly VanBinsbergen and are not necessarily those of Raymond James. All opinions and numbers are as of this 1/22/20 and are subject change without notice.
