“I rob banks ‘cause that’s where the money is” Willie Sutton, entrepreneur
By John Lohr
There has been a lot of news about “The Fed,” and they seem to have some sort of impact on the movement of the markets. But, just exactly what is the Federal Reserve Bank, what does it do, and what is this mystical power it has over us and our economy? Everyone seems to agree that the Fed is important and powerful, but how and why remains obscure due to misunderstanding and misinformation. Let’s try to clear it up, at least a little bit.
The Federal Reserve System, created in 1913 to stabilize the banking system, is the central bank for the United States. To prevent the Fed from falling prey to partisan politics, it is distanced from the government—in its day-to-day business, the Fed operates independently of any governmental authority. The Fed is not a single institution. There are 12 Federal Reserve Banks in major cities and 25 additional branches in smaller cities, led by a seven-member Board of Governors headed by a Chairman, currently Ben Bernanke, and a twelve-member Federal Open Market Committee (FOMC). Members of the Board of Governors are appointed by the President—the only direct political control the Fed is subject to. Individual banks are part of the Federal Reserve System— membership is required for all national banks, and state banks may also join.
The primary responsibility of the Fed is to regulate the money supply—currency in circulation and the deposits and reserves held by banks. If the Fed believes the rate of our economic growth is too rapid, it will reduce, or “tighten” the money supply; if growth is stagnating, the Fed will increase, or “loosen” the money supply. The amount of money in circulation in turn influences the rate of borrowing—it becomes a matter of supply and demand. When more money is available, it is easier to borrow (lower rates, looser credit); when less money is available, the reverse is true. Unfortunately we are a borrowing nation. There is more than $2,545,000,000,000 (trillion) in outstanding consumer debt owed by you and me. In an ideal world the Fed would maintain the health of the economy by fostering low inflation, high employment, moderate interest rates, strong financial markets, and a stable currency. It’s an ideal not often seen. It’s a tough balancing act, so basically the Fed is responsible for preventing things from getting out of control.
The regulation of the money supply is known as “Monetary Policy.” To set monetary policy the Fed carefully manipulates short-term interest rates. There are two types of interest rates affected by the Fed. One is the federal funds rate. That is the rate that banks charge each other for very short-term, overnight loans. The other is the discount rate which is what the Federal Reserve banks charge to lend money to their borrowing members. A drop in the federal funds rate usually results in an immediate drop in the prime rate—the interest rate banks charge on consumer and business loans. (It varies locally from bank to bank.) The difference between the federal funds rate and the prime rate is known as the “spread.” (It is typically three percentage points, although not exactly and not always.) When the cost of borrowing drops because the supply of money increases, demand for borrowing increases. The opposite is true when reserves decrease and the federal funds rate increases. In this case, the prime rate increases, the price of borrowing increases, and demand for loans decreases. Reduced borrowing slows spending, which in turn slows economic expansion.
In the long term, higher interest rates tend to curb growth and lower stock prices, while making bond and cash equivalent investments more attractive; alternatively, lower rates may boost securities prices, as growth makes more investors become comfortable accepting additional risk.
The power group is the FOMC. It holds regular meetings, at which it decides to loosen, tighten, or not change monetary policy, and issues a “Risk Statement” about current economic conditions. These statements are considered reliable indicators of what the Fed plans to do in the future. When the Fed talks, analysts and traders listen and speculate. Suppose the Fed gave an indication that interest rates were going to be cut. Enter the speculators: “How Much?” If the speculators think that rates will be cut by ½ % and the Tuesday Fed announcement is for ¼%, the markets will drop. Period. On the other hand, if the guessers think ¾% would be nice and it turns out ¾% is cut, like last week, markets go up.
So, even speculation about future Fed action, can influence the pace of trading on securities markets, altering securities prices. Public statements by the Fed, especially by the Fed chairman, have a substantial effect on market activity. But we investors put way, way too much emphasis on guessing what the Fed will do. The media fuels much of this by devoting endless hours of coverage to the subject. While we cannot control the actions the Fed takes at their meetings, we can control the way we react to Fed actions. Don’t over react!
So, are higher or lower interest rates better for you and me? The answer is simply, “Yes.” For savers lower rates are lousy. For borrowers higher rates are stifling. Is there a happy medium, where savers and borrowers will both be happy? Not really. Low rates to borrow, high rates to save and a rising stock market is a nirvana you don’t even see in fantasy stories. I believe we can adjust to interest rates and the markets if we see some stability. Unfortunately we haven’t seen much of THAT recently. Change and uncertainty hurt, and when rates and markets are bouncing around like ping pong balls in a room full of mousetraps, we aren’t happy.
John Lohr can be reached at john@howlingwolf.org