Merry Christmas and Happy New Year! (A little late… I know)
It’s great to be back from a short writing break. I got to spend some quality time with friends and family, and I hope each of you did as well.
One of the recent topics in financial news has been the Federal Reserve due to the meeting on December 13-14 and the decision to raise interest rates.
The Fed and its operations can be extremely confusing, but few entities impact your investments to the same extent. For this reason, it is vital to understand what the Federal Reserve is, how it works, and how it impacts the market. If you want to learn what really moves the economy, read on.
Background and Structure
In 1913, Woodrow Wilson signed the Federal Reserve Act into law, establishing the Federal Reserve System. Also known as the Federal Reserve or just the Fed, the Federal Reserve System is America’s central bank, and it holds a similar structure to the bank created over 100 years ago.
Originally, the bank received a 20 year charter, but it was extended indefinitely in 1927. Now, virtually every developed country in the world has a central bank of its own.
The Federal Reserve System is made up of 12 districts, each containing an independent regional reserve bank. These are located in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, San Francisco, and St. Louis. All of the regional reserve banks are under the management of their respective reserve bank presidents.
Regional reserve banks are supervised by the Board of Governors, located in Washington D.C. Each of the 7 members are selected by the President of the United States and approved by the Senate for staggered, 14 year terms.
From this group, the President also nominates the Chair and Vice Chair for 4 year terms. Currently, Janet Yellen is the Chairwoman and Stanley Fischer is the Vice Chairman. The other 3 board members are Daniel Tarullo, Jerome Powell, and Lael Brainard, while 2 seats are vacant.
The Federal Reserve System fulfills 3 primary functions: banking supervision, financial services, and monetary policy.
The regional reserve banks are responsible for overseeing the commercial banks within their districts. This includes evaluating banks for financial soundness and making sure they abide by regulations.
In addition to supervising commercial banks, The Fed provides numerous services intended to aid the economic sector.
It helps financial institutions and other entities transfer money through Fedwire and ACH and processes checks to allow transactions between individuals with accounts in different banks. The Federal Reserve System also loans cash to banks and allows the US Treasury to raise money through bonds. Finally, The Fed conducts vital economic research to aid in policy decisions and strategic planning.
The Fed can either cool the economy off to prevent a bubble and a market crash or it can stimulate the economy to help it recover from a recession. The organization utilizes 3 major tools to implement its monetary policy.
- Changing the discount rate (the interest rate banks pay on short term loans from the federal reserve bank)
- Changing reserve requirements (the percentage of deposits that a bank must hold)
- Open market operations (buying and selling government securities, i.e. savings bonds and treasury notes)
The Federal Open Market Committee (FOMC)
The FOMC is the Federal Reserve’s supervisory body for open market operations, its primary tool for implementing monetary policy and influencing the economy.
All members of the board of governors and each of the regional bank presidents participate in FOMC meetings, but only the board members, the New York regional president, and 4 other regional presidents (on a rotating basis) have the ability to vote on decisions.
The committee decides how many government securities to buy and sell. This influences the federal funds rate, which is the interest rate that individual banks pay to borrow money from one another. Banks often fall below the reserve requirements, so they loan money from one another for short periods of time to cover the minimums.
The Fed cannot set an actual number. Instead, it sets a target rate with a range of a quarter of a percent that it tries to keep the market among banks within. The federal funds rate is the country’s base interest rate, and virtually every other rate moves up and down in response.
The FOMC generally meets 8 times per year, and it votes on whether to raise, lower, or leave the federal funds target. Then, the committee will adjust open market operations to meet its goal.
Why should you care?
Despite most people not having a clue how the Federal Reserve System works, it impacts the economy, real estate prices, bond funds, and the stock market as much as the President, Congress, or international events.
You need to understand The Fed, specifically the FOMC and the federal funds rate, in order to gain an insight into the movement of your investment portfolio.
Right now, the federal funds rate is extraordinarily low in response to The Great Recession. It stayed at 0.00% – 0.25% for almost 8 years in an attempt to stimulate the economy.
Because interest rates were so low, many Americans purchased homes through mortgages that they normally would not have been able to afford. Due to the law of supply and demand, this increase in demand for houses raised real estate prices.
Low interest rates also inflated the stock market. Companies began taking on debt in order to buy back shares of their own stock. Once again, increased demand raised share prices.
Over the short term, low interest rates even allowed investors to make more money on their bond funds. Because new bonds paid less interest than those already on the market, the principal value of existing bonds increased.
However, lowering the federal funds target had drawbacks. Retirees, for example, normally transition into safer investments that provide regular income such as savings accounts, certificates of deposit, and bonds. These individuals cannot achieve a high enough rate of return to afford retirement without using riskier investments, such as stocks. This means that if we experience a correction in the stock market, huge chunks of seniors’ retirement accounts could be wiped out.
Interest rates are at an unprecedented low level, and they cannot stay that way over the long run. For this reason, Janet Yellen and her counterparts have started raising rates in quarter percent increments, and they plan on gradually returning to a federal funds target of about 3%.
This increase is where things get tricky and start to really impact your portfolio. The entire reason why The Fed lowered interest rates in the first place was to stimulate the economy, and raising rates has the opposite effect: slowing down the economy. This means that in order to regain a normal level of interest rates, the market will have to experience some pain along the way.
When The Fed decides to raise the federal funds target during a FOMC meeting, you can expect the stock market, real estate prices, and bond funds to take a hit. At the same time, interest rates on savings accounts, CD’s, bonds, and mortgages will go up.
As you can see, the Federal Reserve impacts the market in a powerful way. The key for you, as an investor, is to understand how it operates and how its actions impact your portfolio.
I hope this article provides you with some insight into the operations of The Fed and the organization’s impact on the economy. However, this was only meant to serve as an introduction.
I highly encourage you to check out more information on the Federal Reserve to gain a comprehensive understanding of its influence on your portfolio.
Thanks for reading, and make sure to like my Facebook page to stay up to date on new content!
Special thanks to the following sources: Federal Reserve Online, Federal Reserve Education, Investopedia, and PBS.