Fathoming Fed Fears
Since December 2008, the U.S. Federal Reserve (the Fed) has held the federal funds rate at zero percent, seeking to bolster an ailing economy in the aftermath of the Great Recession. Economists agree that the position is unusual, and highly unlikely to go on forever – drastic times called for drastic measures. Then again, they’ve been agreeing on that for seven years. Each year, the Fed has had eight opportunities to ease into rate increases, and they haven’t yet.
Will rates move upward in December? Fed Chair Janet Yellen has been suggesting that the answer is at long last … probably. Let’s take a moment to put the unfolding news into context.
What Is the Federal Reserve?
As described on its consumer education site, the Federal Reserve is the central bank of the U.S. It was created by Congress as an independent government agency in 1913 to “provide the nation with a safer, more flexible, and more stable monetary and financial system.” Yellen is its board of governors’ chair. Ben Bernanke was chair before her, and Alan Greenspan before that.
Yellen and her board of governors are based in Washington, DC. They also oversee 12 regional reserve branches across the country and are tasked with three main roles:
- Monetary Policy – Promoting “maximum employment, stable prices and moderate long-term interest rates”
- Supervision and Regulation – Overseeing U.S. banks and gathering information to understand financial industry trends
- Financial Services – Serving as a bank for U.S. banks as well as for the country’s monetary operations – issuing currency, managing the government’s bank accounts, borrowing money in the form of U.S. Savings bonds and more
What Is Going On?
While you wouldn’t want to run a developed country without all three of these roles in place, monetary policy is where much of the headline-grabbing action has been, as the Fed has been grappling with when, by how much, and how frequently it should raise the federal funds rate.
The Federal Reserve sets monetary policy through its Federal Open Market Committee (FOMC), which includes the Fed’s seven board members and a rotating representation of Reserve Bank presidents.
The FOMC holds eight regularly scheduled annual meetings to consider what actions to take (if any). In the days before those meetings, the financial press often reports on expected outcomes as if they were a done deal, and markets often respond accordingly. In reality, until those meetings have taken place, nobody knows for sure what the outcome will be. We saw this in September 2015 when a widely anticipated rate increase did not come to pass after all.
Ordinarily, the FOMC has a number of ways to seek balance among the competing demands of the economy. But while the federal funds rate remains at zero, their usual arsenal has effectively been reduced to a single bullet: Will they or won’t they raise that rate?
It’s no wonder the question has become the central focus of recent FOMC meetings. It’s also no wonder that investors have been bombarded with the usual volume of conflicting coverage on what is and is not at stake. Depending on who you heed, rising rates could be anything from a panacea, to a global scourge, to a non-event in the markets.
What Does All This Mean to You and Your Money?
First, it helps to understand that there is an intricate interplay between developed nations’ monetary policies, global interest rates and the markets in general – and that these components are nowhere near one in the same. Anyone who claims to know exactly what will happen in one arena when we pull a lever in another had best be able to present a functioning crystal ball if he or she is to be believed.
To understand the complexities involved, consider this insightful article by Bloomberg View columnist Barry Ritholtz: “You’re the Fed Chairman. What Would You Do?” In short, monetary policy-setting is neither as easy nor as obvious as you might think.
It’s also worth emphasizing that the only interest rate the Fed has direct control over is the U.S. federal funds rate, which is the rate at which depository institutions (mostly, banks), lend and borrow overnight funds with one another.
The resulting cash flow is the grease that turns the wheels of our federal banking system, so it’s an important factor. But that doesn’t mean that there is a consistent cause-and-effect relationship between federal funds rate movements and other yields-based financial instruments such as U.S. or international fixed income funds, interest-earning accounts, mortgages, credit cards and so on.
As this Wall Street Journal article describes, “Think all rates would tick a little higher as the Fed tightens? That isn’t how it works. … The impacts will be uneven. Some borrowing costs are likely to rise closely in sync with short-term rates, but others won’t.”
Why is this so? It’s the result of those multiple global factors at play, with the Fed’s actions representing only one among them. A post by “The Grumpy Economist” John Cochrane even suggests that the Fed’s actions may be one of the less-significant factors involved, as he comments: “Lots of deposits (saving) and a dearth of demand for investment (borrowing) drives (real) interest rates down, and there is not a whole lot the Fed can do about that. Except to see the parade going by, grab a flag, jump in front and pretend to be in charge.”
What Should You Do?
Whenever you’re wondering how best to respond to a shifting landscape such as that wrought by rising (or falling) interest rates, begin by asking yourself: What can I do about it?
Unless you are Janet Yellen, there is probably nothing you can do to personally influence what the Feds are going to decide about interest rates, or how the global markets are going to respond to the news. But there is plenty you can do to help or harm your own wealth interests.
First, if you already have a solid financial plan in place, we do not recommend abandoning it in rash reaction to unfolding news. If, on the other hand, you do not yet have a well-built plan and portfolio to guide the way, what are you waiting for? Personalized financial planning is a good idea in all environments.
Next, recognize that rising or falling interest rates can impact many facets of your wealth: saving, investing, spending and debt. Every real investor needs an investment plan designed to both mitigate and make the most of the multi-factored influences of the unfolding economic news.