The Fed and its Decisions on Interest Rates

We read and hear quite often that President Trump is very dissatisfied with Federal Reserve Chairman Jerome Powell for not moving more aggressively on cutting interest rates. The President has even made the comment that the central bank chief has "no guts."

In this post, we will examine the Federal Reserve’s role in our economy and how interest rate fluctuations impact the U.S. and international markets. Politics aside, I'd like to explore this topic in a little more detail.

The Birth of The Federal Reserve

Let’s start at the beginning. The Federal Reserve, also known as “The Fed”, was founded in 1913 by the U.S. Congress following the signing of The Federal Reserve Act by Woodrow Wilson. A few years earlier in 1907, there was severe panic that gripped the nation due to a major banking crisis stemming from a large decline in market liquidity and depositor confidence. Many banks and businesses, both state and local, entered bankruptcy as a result. This generated a great need for a reliable and secure financial institution that could prevent this kind of panic, which is where the Fed came in to play. While this was the initial need at the time, the Fed has now expanded its responsibilities, ensuring that we have a dependable banking system and healthy economy.

Today, the Fed functions as a means of maintaining a safe, flexible and stable monetary and financial system which balances the private interests of banks along with the centralized responsibility of the government. It focuses on the supervision and regulation of banks and other financial institutions to ensure that the credit rights of consumers are protected.

Also referred to as America’s central bank or the “banker’s bank”, the Fed is responsible for determining the money supply and providing banking services to the federal government. Maintaining a strong central bank is beneficial not just for the U.S., but also for foreign businesses, individuals and governments doing business with us. In conducting monetary policy, the Fed’s goals are to maximize employment, maintain stable prices for the goods and services we consume and to foster moderate long-term interest rates.

Who Oversees the Fed?

The Federal Reserve is not owned by a single person but is supervised by the Board of Governors located in Washington D.C. consisting of seven members nominated by the President and confirmed by the Senate. The Board has the duty of setting the discount rate and reserve requirements which we will discuss later. This agency is responsible for reporting to Congress, to whom they are directly accountable. Ironically, they are not funded by Congress.

The Board of Governors is responsible for overseeing the 12 Reserve Banks located in various cities across the U.S. These banks preside over regional member banks and protect regional economic interests.

The monetary policy-making body of the Fed is called the Federal Open Market Committee (FOMC). This group consists of twelve members: the seven Board of Governors members and five of the twelve Federal Reserve Bank presidents. This committee holds eight meetings a year where they review economic and financial conditions and weigh the costs and benefits of their long-term goals of price stability and sustainable economic growth. An important consideration for the FOMC is the federal funds rate which I will elaborate on as we move further.

These three entities are what make up the overall structure of the Federal Reserve, all playing a key role in health of our economy.

The Important Role of Interest Rates in Our Economy

Now that we have a general understanding of the composition of the Federal Reserve and its operations, we will look at how interest rates factor into this discussion and the Fed’s influence over them.

There are both positive and negative effects that interest rates can have on U.S. markets, impacting stocks and bonds, inflation and the possibility of recession. When the Fed loans money, they accept the risk of not being repaid. To compensate for this, they have interest on the loan.

From 1971 to today, interest rates have averaged 5.65%, peaking at 20% in March of 1980 and reaching a record low of 0.25% in December of 2008.

The specific interest rates I am talking about are the federal funds rate and the discount rate. These are two of the greatest tools that the Fed uses to set monetary policy in the U.S. The former is defined as the interest rate at which banks charge other banks on an overnight basis to meet reserve requirements. If a bank fails to meet the reserve requirements, it has the option to borrow money from the Fed or other banks that hold funds at the Fed. The Fed tries to keep this rate between 2-5%. On September 18th of this year, the FOMC lowered the federal funds rate to 2%.

The other interest rate, called the discount rate, is the rate at which an eligible financial institution can borrow funds directly from the Fed’s discount window to maintain reserve requirements. Effective August 1st of this year, this rate has been lowered to 2.75%.

The Fed cuts interest rates to incentivize consumers to borrow in order to increase spending, which boosts economic growth. This is why after the Great Recession, they kept rates at nearly zero. When too much growth occurs, they will increase interest rates to decelerate inflation and return growth to a more sustainable level.

The recent cuts have created mostly positive effects for households and businesses here in the U.S. such as lower rates for credit cards, mortgage loans and auto loans but there is also speculation about what this could mean for the possibility of a recession. Another issue posed is that of markets abroad and how they might be affected by these cuts.

Thoughts on Further Cuts and What it Could Mean for International Markets

These recent cuts have given analysts mixed feelings about the impact they could have on the economy. While they were expecting these lower interest rates, some thought the Fed didn’t go far enough.

Neel Kashkari, who is the president for the Minneapolis Federal Reserve Bank, believes that the Fed should lower interest rates even more because the economy has not yet reached its maximum potential. Kashkari says “I argued for steeper interest rate cuts just because I see no evidence that the U.S. economy is running at capacity or beyond capacity. There’s no reason we should have interest rates trying to hold the economy back." Kashkari even says that the possibility of negative interest rates cannot be ruled out.

President Trump is in favor of negative interest rates and argues that this would greatly improve the economy and would allow the federal government to refinance its debt at a lower cost. Rates below zero would mean that banks would have to pay a monthly fee to keep a portion of their money at the Fed which isn’t how they usually operate. In that case, banks could transfer those interest costs to customers by charging for deposits. Essentially, account holders would have to pay to keep money in the bank, motivating them to spend rather than save.

PhD economist and fund manager, Daniel Lacalle, has lot to say about the Fed and the way they handle interest rates. In a recent July article, Lacalle asserts that there is no objective data that justifies cutting interest rates. He thinks that rates are already “artificially low.” He presents two reasons why the Fed would cut rates: 1) The Fed expects the economy to worsen (despite claims of a “solid” economy) and 2) As a response to the monetary assault from foreign central banks such as the ECB, PBOC and BOJ. The Fed is aware that we are in a dangerous bubble inflated by central banks, foreshadowing the likelihood of a currency war.

It is apparent that policymakers are divided on this issue. Some argue that rates should drop further by year-end, others believe that they should remain unchanged, and several are opposed to the recent cuts and think that rates should be higher come December.

Amid signs of slowing economic growth and a possible recession, the recent cuts were intended to prompt businesses to take out loans so they could hire more workers and expand production. The chair of the Federal Reserve, Jerome Powell, has taken some heat from President Trump for not pushing for further cuts. He has provided reassurance that “The U.S. economy itself – the consumer part of it – is in strong shape.” Powell says that the economy is doing great with all-time low unemployment and higher wages but adds “If the economy does turn down, a more extensive series of rate cuts could be warranted.” Powell is open to hearing all sides and will decide on further cuts as he sees fit.

It’s not certain whether lowering interest rates will be of much help to the manufacturing sector and some economists seem to agree. Deutsche Bank’s Chief U.S. Economist, Matthew Luzzetti, has voiced concern that cutting the federal funds rate will not be able to “fully alleviate that uncertainty.”

As I touched on in last month’s post, the ongoing trade war between the U.S. and China has slowed global growth and negatively impacted manufacturing and exports which in turn has raised prices for American consumers. This dispute has reduced investments in businesses. These cutbacks on investments are not because it’s too expensive to borrow money, but due to the lack of certainty as to whether businesses can sell their products. This trade war has sparked fear of a recession and if we see a decline in job growth and consumer spending, then rate cuts will certainly be on the table.

As you can see, there is such a wide spectrum of opinions on what the Fed should do. Should rates go up, down, in the negatives, or unchanged? Only time can tell. There are so many variables that must be considered in order to make a concrete decision. Policymakers have a big decision ahead of them and one thing’s for sure – it won’t please everyone.

Sources Used:

Fed Cuts Interest Rates to Prop Up the Slowing Economy

Fed's Kashkari: U.S. Economy Needs Lower Interest Rates

Here's How the Fed Sets Interest Rates and Why it Matters

Fed Lowers Interest Rates Again to Stave Off Recession

The History and Responsibilities of the Fed