Interest Rates, the Federal Reserve, and the Economy

The Federal Reserve announced on  December 14, 2016 that they were increasing the federal funds target rate by 0.25%. This move has been much anticipated and was certainly not a surprise, but does say a lot about the state of the economy and has long-term implications for both stocks and bonds. I thought I’d take a few minutes to write about how and why the Federal Reserve manipulates interest rates, and how those changes might play out in the markets.

The Federal Reserve controls the federal funds target rate. This interest rate, often called the fed funds rate for short, is the interest rate that banks charge each other for short-term loans from their reserves. While the rates for these loans are negotiated by the banks making them, the fed funds rate is the collective average rate for those loans.

All other interest rates, the ones with which we deal as consumers, are set by supply and demand. Banks set their own rates for mortgages and business loans, and they also set their own rates for deposit accounts like savings and money markets.  When banks want to make more loans, they keep their loan rates low. When they want to attract more deposits, they increase what they pay for their savings accounts. However, changes in the Fed Funds Rate tend to lead to changes in interest rates overall.

Why does a change in this rather obscure interest rate that affects banks lead to changes in the overall interest rate environment? Like so many things in finance, it comes down to risk and reward, as well as cost. Banks are in the business of borrowing money from their depositors at one interest rate and then loaning that money to other customers at a higher interest rate. When they make loans, they are taking on risk. Every day, banks have a choice: loan excess funds out to clients and take risk, keep the funds themselves in their account at the Federal Reserve or loan them to other banks and earn risk-free interest. When the fed funds rate is higher, the banks will demand higher rates from their loan customers to justify taking the risk, as well as to offset the increased cost if they have to borrow funds from another bank to help make the loan. So, when the Federal Reserve increases the rate that banks can make risk free, the rates that require banks to take risk tend to move up as well.

But why does the Federal Reserve want to increase interest rates? When they raise interest rates, it acts as a brake on the economy. Lowering interest rates stimulates the economy. Continuing with our view of interest rates and the relationship between risk and reward, when banks are encouraged to make more loans at lower rates, because they are not going to make very much by leaving funds with the Federal Reserve, their customers will do more things. They will buy more houses, they will build more factories, and they will hire more workers for those factories, who will then buy more homes… you get the idea. So when the economy was crashing during the last recession, the Federal Reserve lowered the Fed Funds Rate all the way to zero so that banks would want to make as many loans as possible.

Fast forward from 2008 to December 2016: The economy has been growing, albeit not fast enough for a lot of people’s taste. Why would the Federal Reserve want to slow things down by raising rates? Because if economic growth becomes “overheated” inflation will get out of control and the economy can become unstable. The Federal Reserve is like Goldilocks when it comes to the economy and inflation: they want enough inflation to indicate that the economy is growing but not so much inflation that the economy becomes unstable and prices spiral out of control. By controlling interest rates, the Federal Reserve is trying to moderate the boom – and – bust cycles that were so common for the first two centuries of America’s economic history. Time will tell how effective they are at the job.

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