What’s the Deal with the Fed?

August 27, 2019

There is so much out there in the investment world about the Federal Reserve and for the everyday individual, you may have heard about the Fed but do not understand what it really is or does.

What is it?

The Fed is the central bank of the United States of America. Basically, it controls the monetary policy through interest rates in order to increase, decrease, or stabilize the country’s money supply. The Fed’s goal is to promote growth within the economy through monitoring the money supply, protect financial institutions, and allow transactions of the U.S. dollar. Although the Fed has many other responsibilities, for the purpose of this article, we will address broad concepts.

What does raising and lowering rates mean? When the Federal Reserve raises discount rate, essentially what that means is when the banks borrow money from the Fed, they are charged more per dollar. Because it costs banks more to borrow money, they charge the consumer a higher rate to borrow money from them. Banks have to stay in business too right? It’s similar to if the tree company raises their prices on wood. A cabinet maker now has to pay more for the wood but still needs to make a profit so he or she charges more for his cabinets.

One thing to note is that the Federal Reserve is its own entity and is not run by the president or the White House. Jerome Powell is the president and is responsible for all the final decisions of the Fed.

Raising and lowering rates

Now that we addressed what the Federal Reserve actually is, let’s talk about what happens when they raise and lower interest rates. You obviously want to know how raising and lowering interest rates affects you right, continue reading to find out!

OK let’s talk about lowering interest rates first. When the Federal Reserve wants to stimulate economic growth, they often cut interest rates. What does this mean? When interest rates are lowered, the interest on loans decrease. Less money to pay towards a loan means more money in the consumer’s pocket so more money to spend, hence, stimulating growth. For anyone looking to take out any kind of loan, this is very beneficial because you will owe less money in the end.

On the flip side of lowering interest rates, with the Fed trying to encourage growth, interest rates for savings, money market, or CD accounts is also lower. They are almost discouraging you to put your money into savings because you could only earn pennies. The Fed wants you to spend money not save it.

Next is raising interest rates. When the economy has too much growth and inflation begins, the Fed will raise rates. Having less money in the consumer’s pockets for those with loans will help slow down the economy. Essentially, this is the reverse of lowering rates. For anyone who needs a loan, the interest rates are higher thus you will be paying more for your loan.

On the flip side of raising rates, higher interest rates are beneficial for anyone with a savings, money market, or a CD account because your interest rates will be higher and generate more income. The Fed is encouraging individuals to save their money instead of spending it to combat inflation and stabilize the economy.

How does this affect the stock market?

While interest rates do not have a direct affect on the stocks and bonds market, it does have a ripple effect. If the interest rates are high, businesses are discouraged from taking out loans for capital expenses thus there is limited growth and limited productivity within the company and therefore can cause the stock to fall.

The other side of raising rates that can indirectly impact the stock market is the consumer side. Raising rates means less money available in the consumer’s pocket which leads to fewer dollars to spend in the economy. If fewer people are spending money at businesses, then the business’s profits decrease causing the stock to fall.

For bonds, interest rates have an inverted effect. When interest rates rise, the price of bonds will fall. Typically bonds sell for $1000; if interest rates are higher than bond rates, more people will go for CD or money market accounts because they will earn more in interest. This causes bond prices to fall below $1000. With the reverse, when interest rates are lower than bond rates, bond prices will increase to more than $1000. The bonds become more valuable and similar to stocks, the price goes up.

Overall, the Fed can be a confusing concept but hopefully, this article helps clear up some confusion!