The Federal Reserve and its chairman, Jerome Powell, seem to be in the news a lot more frequently than in recent memory. While previous administrations have privately sparred with the Federal Reserve over their policies, it is pretty unprecedented for the executive branch to publicly criticize and attack the Federal Reserve and its chairman. We thought this month’s article would be a good time to talk about the role of the Fed and how their policies impact you.
Brief history and overall structure
The Federal Reserve was formed in 1913 when President Woodrow Wilson signed the Federal Reserve Act. The law created an independent agency, the Board of Governors, and 12 regional Federal Reserve Banks throughout the country. It’s important to point out that the Federal Reserve is not funded by Congress. It is funded mainly through the interest it earns on the securities it owns. In the broadest definition of the role of the Federal Reserve, it is responsible for the following: setting monetary policy, supervising and regulating banking institutions, maintaining stability of the financial system, and providing financial services to depository institutions, the U.S. Government, and foreign official institutions. (Source: federalreserve.gov). Since 1977, the Federal Reserve’s monetary policy goals have come to be known as the “dual mandate,” which are the “goal of maximum employment” and “goals of stable prices and moderate long term interest rates.”
Even though the Federal Reserve has several responsibilities, the one that gets the most attention and the one we will focus on is monetary policy. If we look closer at the dual mandate, monetary policy boils down to two goals: maximize employment while keeping inflation low. How the Federal Reserve tries to do that can be likened to walking a tight-rope. If you focus too much on one, the other tends to suffer. The three traditional tools that the Federal Reserve has at its disposal to conduct monetary policy are: open market operations, manipulation of the discount rate, and changing of reserve requirements for banks. If the Federal Reserve is utilizing expansionary monetary policy, it may lower the target federal funds rate as well as buy securities from banks in order to inject liquidity by increasing the money supply. When banks have more money in their reserves to lend, they in turn will lower their federal funds rate (the rate banks charge to loan to other banks) in order to lend out their excess reserves to other banks. The goal of expansionary monetary policy is to spur economic growth but a side effect might be increasing inflation. Right now, what we are currently seeing is a contractionary monetary policy from the Federal Reserve. Since unemployment is at record low levels and economic growth has been strong, the concern is that the economy can “overheat.” The Federal Reserve has had to figure out a way of lifting the target federal fund rate off the floor in order to tamp inflation but not slow economic growth. It has been slowly increasing the target federal funds rate periodically since December 2015 and selling securities in order to shrink the money supply.
What monetary policy means for you
In the past 10 years, consumers and businesses have gotten used to cheap credit. Considering that the federal funds rate was close to 5.25 percent in 2006 and as of September 2018 sits at 2.25 percent, it’s still pretty low. However, the Federal Reserve took (and quite frankly needed to take) extraordinary action during the Great Recession. One of the tools it used was lowering the target federal funds to close to zero by December 2008 in order to try and maintain liquidity in the credit markets. By gradually increasing the target federal funds rate it means that if in the future, the Federal Reserve needs to cut rates again, it at least has the ability to do so.
In the meantime, higher interest rates means borrowing money will be more expensive for both consumers and business. If businesses carry a lot of debt on their balance sheets, this can be problematic in the longer term. Also, generally speaking, as interest rates increase, bond prices tend to decrease. However, not all bonds react the same way. Stock are more indirectly affected by rising interest rates. On the one hand, if you view that interest rate increases often coincide with a strong economy, this may be a positive sign for stocks. On the other hand, stock prices are often affected by expectations about future cash flows and earnings. If a company’s borrowing costs increase, this may affect their profitability.
Gary E. Croxall, CFP®
Registered Principal of LPL
Soren E. Croxall, CFP®
Registered Representative of LPL
Securities and Advisory Services offered through LPL Financial, member FINRA/SIPC, a Registered Investment Advisor. LPL Financial and Croxall Capital Planning do not provide tax or legal advice. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.