Who is the Fed and Why They're so Important

Transcript:

Hey guys, Mike Frontera here, back with another edition of Retirement Theory.

You know, there’s nothing more frustrating to me than being told that something is really important, but at the same time not understanding what I’m being told. Such is the case for many people with interest rates.

We’re constantly bombarded with news about the Fed and whether they’re going to raise rates. You might see something on CNBC or the nightly news about a huge drop in the stock market and hear something like “the market plunged today after the Fed raised its target rate by ¼%”.

Here’s a real example from December in fact.

So what the heck does that headline mean, and if it’s bad for the stock market, why would they do that??

Well let’s start with a quick definition of who is the Fed. The “Fed” is short for the Federal Reserve Bank, and it is the central bank of the United States. It was created over 100 years ago by Woodrow Wilson in order to provide additional stability in our banking system. The Fed can provide loans and liquidity to commercial banks, and it has several functions to help the US economy on an ongoing basis. Two of the Fed’s primary objectives are maximum employment and stable prices. And its manipulation of interest rates is a vital tool in helping them achieving those goals.

OK, you made it through the first minute or so and you already know more about who the Fed is than most people out there. If you want to know even more, go to www.federalreserve.gov. Buckle up though, because it’s a wild ride.

Now you may have heard a headline like I mentioned before about the stock market going down after after the Fed raises interest rates, also called a rate hike. So why do rate hikes typically hurt stock prices? Well there are three big reasons:

1. First is that it makes other types of assets compete better against stocks, thus making stocks less attractive. For example, an investor may determine they need a 5% rate on their money to meet their goal. If CD rates moved from say 2% to 5%, they would likely want to pare back the amount of money they have invested in stock and simply hit their goal with a safer investment.
2. Second is that a great deal of business is transacted on credit. As interest rates go up, so does the cost of doing business. Depending on the amount of money a company is borrowing, this can have a major impact on their bottom line.
3. Third is the direct impact that higher rates have on stock values. A company’s valuation is highly tied to interest rates. In fact, stock prices are often said to simply be the present value of all future cash flows. In other words, the value today of all the money a company expects to earn in the future. As you know, a dollar now is worth more than a projected dollar 10-years from now. And when making that calculation, higher rates of interest diminish that future value more than lower rates of interest.

All this sounds bad. So if the Fed is trying to help our economy, why would it raise rates?

One primary reason is to help combat inflation. It’s a bit of pain now to hopefully avoid major hurt down the road.

You may hear that the economy is too hot and the fed wants to pump the brakes. But, why? Don’t we want a hot economy? Well we do to a degree. But if you take a step back, you may see an insidious byproduct of a hot economy, which is inflation. Look at this quick example:

Mary has a grocery store business. Business is great and revenues are way up. In fact, everyone’s revenue in town is up with this hot economy. That means every person has more money in their pocket. That also means they may be more likely to spend that money. Especially when you’re not getting paid a lot of interest to keep it in the bank.

With an increasing demand and declining supply of her groceries, Mary decides to increase her prices. They also have to increase the supply in order to keep up with the demand. They need more employees to help keep up, but they’re already the biggest employer in town and there’s not a lot of available workers because of all the other successful businesses in this hot economy. So they need to pay employees more in order to entice them to work for them. More income to the employees means more money in the system.

As prices of other goods begins to rise to meet demands, people begin to be incented to spend even faster. After all, holding onto their money means it’s going to buy less stuff soon. This means more demand for goods and more rising of prices. And consequently, less value for each dollar that people have. 

While this can quickly become quite problematic for folks on a fixed income, like social security beneficiaries, businesses like Joe and Mary’s eventually get hurt too. The revenue they’re taking in buys less and less stuff for them.  It becomes less attractive to feed money into their business as it’s hard to beat the rate at which prices are rising.

Somewhere along the way, it’s up to the Fed to increase rates to slow things down. Increasing rates makes it more attractive to keep money in the bank rather than spend it. It also increases borrowing costs, thus making people and businesses spend more on servicing their debt that they have and consequently consuming less. As consumption and demand falls, the pressure to increase prices does as well. And while this can all be an unpleasant thing to go through, rising rates can be very helpful in curbing runaway prices.

So…do you have questions for me? Let me know. Give me a call at (518) 612-1060, or just visit www.retirementtheory.com . Do you follow me on Facebook? I think that you should. You'll see videos like these, and get blog and article shares on everything retirement planning. Once again, thank you for joining me. See you next time.