Good morning & happy Monday!
“Unlike the days of the gold standard, it is impossible for the Federal Reserve to go bankrupt; it holds the legal monopoly of counterfeiting (of creating money out of thin air) in the entire country.”
Murry Rothbard, American economist 1926-1995
Ok, I know you’ve been waiting with bated breath to learn about the Federal Reserve 😉
The Federal Reserve, also known as the Fed, is an exceptionally powerful organization. The Fed chair is Jerome Powell and a strong argument can be made that the Fed chair is the most powerful person in the world.
Now, what does the Fed do?
By the book the Feds objectives are “to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”
The tools that the Fed has at their disposal are pretty extensive, but I’m going to focus on their very powerful tool of the setting of interest rates in this memo.
The Fed controls the interest rate they lend money to banks, which in turn affects virtually every level of borrowing throughout the country. Banks will adjust their rates (both on deposits & loans) based on the rates charged by the Feds. The rate set by the Fed is referred to as the prime lending rate.
Currently the prime lending rate for banks (AKA the federal discount rate) is 0.25%, for consumers the prime lending rate is 3.25% … historically these are very low rates. That means the Fed lends money to banks with an interest rate of 0.25%, and then banks lend to their customers at around 3.25% (can vary based on bank, product, etc.). The Fed adjusts those rates to either heat up or cool down the economy based on the metrics they evaluate.
Let’s say the U.S. economy is going gangbusters, employment market is strong, and the Fed is concerned about inflation getting above its target they could RAISE the interest rates. How does that affect consumer behavior? Well, most credit cards, lines of credit, etc. are based on the prime lending rate. If the Fed increases the interest rates it means it is more expensive for consumers to purchase things.
As an example, let’s say the Fed raised the rate by 2% (they usually only adjust by 0.25% or 0.50% at a time), that means that my home equity line of credit rate would go from 3.25% interest rate to 5.25% interest rate. If I was thinking about remodeling my home and borrowing $100,000 from my home equity line of credit my interest only payment would go from $270/month with an interest rate of 3.25% to $437/month with an increased interest rate of 5.25%. With that increased cost of borrowing, am I more likely or less likely to borrow the money for the remodeling project? I’m less likely to do it as it will cost me more for that project. There will plenty of people across the country who will not purse borrowing money (and thus purchasing goods & services) because of the increase costs, thus causing the economy to cool down. So, if the Feds want to COOL the economy, they RAISE the interest rates.
Alternatively, let’s say the U.S. economy is struggling and unemployment is high … the Feds will want to get people to spend more money. How do they do that? They LOWER the interest rates by making it cheaper to borrow money, thus encouraging people to borrow money that is then circulated throughout the economy that in turn improves the economy (more money flowing through). So, if the Fed wants to HEAT UP the economy, they LOWER the interest rates.
When COVID-19 first came on the scene in the U.S. the Fed lowered the interest rates dramatically to try to stimulate the economy and avoid a deep recession. Those rates have remained low since that point.
Low interest rates reward borrowers and punish savers.
Low interest rates are used to stimulate a sluggish economy.
High interest rates reward savers and punish borrowers.
High interest rates are used to slow down an economy that is deemed too hot.
A normal consumer prime rate is in the 4%-6% range. Those rates would be a fairly neutral Fed policy … neither trying to stimulate or slow down the economy.
Many of my clients have been on the short end of the stick on this interest calculation as they were borrowing money as young people in the 70s & 80s when interest rates were extremely high (10%-15% mortgage rates were not uncommon). Now they are retired and fixed rate investments pay low yields (like 1% or 1.5% CD rates at a bank). These interest rates are a very important factor in financial management.
Ok, that’s probably enough for one day 😊 Fed policy is a very complicated topic and one that has many moving parts, but hopefully this fairly high level overview was helpful if you have interest … if you’re still awake 😉
As always, please never hesitate to reach out with questions or to learn more about any of the topics we discuss in these weekly memos.
Make it a great week ahead!