Who Is the Fed and How Does It Affect Your Finances?
The Federal Reserve regularly dominates financial headlines, and yesterday was no exception, but their announcements can often seem like they are speaking a different language. What is the Fed and why are so many people paying so much attention to it? More importantly, does it affect your financial life?
In short: yes. Listening to the Fed can help you understand what the economy is like at the moment, what will happen, and how it will affect your business, your work, and / or your investments. It sounds complicated, but knowing the basics can go a long way.
Anyway, what is the Fed?
The Federal Reserve System (also known simply as the ” Fed “) is not a government agency. Although its Board of Governors is appointed by the President of the United States, it is actually owned by private banks and operates independently. When it was created, it was privileged to manage the US economy on the condition that it fulfilled three objectives: maximizing employment, stabilizing prices, and moderate long-term interest rates.
In general, when the Fed cuts interest rates, the goal is to stimulate the economy. Conversely, they usually raise rates when they want to slow down economic growth.
What the Fed is striving for
The Fed manages interest rates through one of its committees, the FOMC ( Federal Open Market Committee ). The FOMC meets 8 times a year and issues a press release at the end of each meeting, which is considered the most authoritative “state of the union from a financial point of view.”
Union liberation always makes headlines in the financial news. Each major new network reports on what the chairman said and then moves on to “reading tea leaves” about what that “really means.”
Understanding what the Federal Reserve is saying and why they are saying it will help you avoid being criticized by experts and news articles. Like an airplane or ship that needs navigation points for safety, the FOMC has two main navigation points to direct its actions. He wants:
- Unemployment will be less than 5%
- Inflation should be as close to 2% as possible
So when you read the media reports on unemployment and inflation, you should compare these numbers: as we get closer to these targets, we can expect that interest rates will start to rise.
In addition, they also look at GDP ( gross domestic product ) growth as an indicator of the overall economic health and strength of the dollar relative to other foreign currencies.
Where are we now
We are at a historic turning point: interest rates have steadily declined over the past thirty years, as you can see from the following chart of the federal funds rate , the rate that underlies all the interest rates we see, from savings to mortgages to auto loans:
As you can see, this indicator is equal to zero or close to it – you cannot lower it. It is easy to see why most observers expect the long-term downward trend in interest rates to reverse in the near future.
At the end of 2014, the unemployment rate was 5.7%: not much, but decreasing. Inflation looked like it could get close to their 2% target, but then the fall in oil pushed it down again. Since then, unemployment has dropped to 5.5% at the end of February, and some people think the Fed will consider that “close enough.”
Janet Yellen (the current chairman of the Federal Reserve) said on March 18 that the Fed is unlikely to raise rates until the summer of 2015, but if the economy continues its current pace of improvement, we can expect a long-awaited increase in interest rates at any future meeting dates (the schedule of which you can be seen here ).
If economic growth (defined as GDP growth) is too low, the Fed will not raise rates because it will drive the economy into recession (defined as two consecutive quarters of negative GDP growth). GDP growth in 2014 was about 2%, which is the low side of the acceptable. So far this year, it has gone down, not up, which is one of the main reasons the Fed is gently slowing down (the slowdown is the rise in interest rates).
How the Fed’s actions affect your wallet
When the Fed finally raises interest rates, several things can be expected. First, the days when you had nothing in your savings account will gradually disappear. (Hurray!) It won’t happen overnight, but you can expect more return on all interest-bearing investments.
Unfortunately, loans and other types of debt will cost you more when interest rates rise. (Boo!) So get out of as much debt as possible. If you have a variable rate mortgage, now is the time to switch to a fixed rate mortgage.
As interest rates rise, the market value of bonds and bond funds will fall. The cash you receive on a quarterly basis from your existing investments will not change, but bond prices and interest rates change in inverse proportion: when one rises, the other falls. So when you rebalance and sell some of your bond funds, expect losses. On the other hand, as rates continue to rise, you can expect new investment returns to continue to rise in the near term.
More broadly, rate hikes often lead to poor economic performance. This could start with a severe drop in the stock market, which would then push the economy into a full-blown recession. You can see this in the chart above – the shaded gray bars represent recessions, and you can clearly see how rising interest rates precede recessions. We can never say for sure how long it will take until the next crash , but a rise in interest rates usually marks the official start of “watching the crash.” (This is why so many people are fixated on what the Fed is doing these days.)
This means that if you have a business, now is not the time to expand. Fixed overhead and debt are two of the biggest business killers in a recession. Starting a new business now is most likely a bad idea for the same reason. If you are confident that your new business is completely safe from the recession, go ahead, but don’t say you weren’t warned.
If you’re ready , a recession isn’t a bad thing. This is actually one of the best phases of the economy because everything is cheap, from investments to cruises. As someone once said, winter isn’t all that bad if you’re in the Bahamas. The key is being prepared. Forewarned is forearmed, and if you follow the Fed’s instructions, you will always be forewarned.