Highlights

  • The Federal funds rate can have a major impact on the U.S. economy and thereby the stock market.
  • There are pros and cons to raising and lowering the Federal funds rate.
  • It’s impossible for the Federal Reserve to please everyone.

You see, you can’t please everyone, so you’ve got to please yourself.

-Lyric from “Garden Party”, by Ricky Nelson

In 1907, America suffered through one of the worst financial crises of its history.  Known as the Panic of 1907, it was triggered by a failed attempt to corner the copper market, which led to a massive bank run.  The run triggered bank failures and cut the value of the stock market by half.

The following year, Senator Nelson W. Aldrich (John D. Rockefeller Jr.’s father-in-law) chaired a commission to investigate the crisis.  The committee’s findings and recommendations led to the adoption of the Federal Reserve Act, which President Woodrow Wilson signed into law on December 23, 1913.  Thus, the Federal Reserve System was born.  

“Monetary Policy” refers to Fed actions that are intended to promote national economic goals.  Congress has directed that monetary policy should (i) encourage maximum employment, (ii) promote stable prices, and (iii) moderate long-term interest rates.  The first two objectives are commonly referred to as the Fed’s “dual mandate”.

The Federal Reserve’s Open Market Committee (FOMC) is the central bank’s monetary policymaking arm.  The primary tool at its disposal is adjusting the Federal funds rate — the interest rate charged for overnight loans between banks to maintain reserve requirements. 

The Fed funds rate can have a major impact on the U.S. economy, and thereby the stock and bond markets.  There are always pros and cons to lowering (or raising) interest rates.  The benefits of an “easing policy” include:

  • A lower Fed funds rate can fuel economic growth by allowing banks to lend money less expensively. This, in turn, lowers the cost of mortgages, auto loans, and other lines of consumer credit, which encourages consumer spending and promotes economic growth. 
  • When commercial loans are cheap, the private sector has an easier path for financing growth and creating jobs. As a result, unemployment typically falls and wages rise as borrowing costs slide. 
  • Lower borrowing costs also improve banks’ profitability, and thereby their ability to lend.
  • The increased demand for assets brought on by the ability to borrow more easily and less expensively usually lifts asset prices, strengthens corporate balance sheets, and improves household wealth.

Unfortunately, there are also serious risks to keeping Fed funds too low for too long:

  • If rates are already low and the economy enters a tailspin, the Fed is without one of its most powerful tools for stimulating the economy.
  • Easy borrowing at low rates can encourage too much spending, which can in turn cause the inflation rate to soar above the Fed’s 2% inflation target. By comparison, higher borrowing costs and tightening credit encourages businesses and individuals to live within their means, and leads to more rational decision making.
  • Low interest rates on bank deposits discourages saving, which leaves the economy more vulnerable to future economic slowdowns.
  • If the yield generated by safe investments (such as bank deposits and Treasuries) is too low, investors may be tempted to invest in riskier investments such as stocks, causing stock prices to be inflated, and thereby increasing the risk of a market crash.

The FOMC meets eight times a year.  After each meeting it announces its decision on whether to raise, lower, or leave the Federal funds rate unchanged.   The FOMC’s most recent meeting concluded last Wednesday.  As had been expected, the FOMC announced to keep the benchmark lending rate at between 2.25 percent and 2.5 percent, where it has been since December 2018.  (The vote was 9-1.)  However, the Committee also signaled that it might lower rates later this year.  (The Fed has not cut interest rates in more than a decade.) 

The Fed’s announcement has already been praised and criticized by pundits and politicians alike.  President Trump has been pushing hard for a rate cut for several months, and recently has gone so far as suggesting that he may fire Federal Reserve Chairman Powell if he doesn’t ease the policy soon.  (The President’s authority to fire the Federal Reserve Chairman is questionable at best.) 

Trump and others who share his point of view think the time is right for a rate cut because economic growth has slowed recently, inflation is tame, and some leading economic indicators (most significantly, the flattening yield curve) are suggesting that a recession is looming. 

Opponents of a rate cut argue that employment is near record highs (and unemployment near record lows), GDP growth remains strong at a projected 2.5% for the first part of the year, borrowing costs are low, and banks are lending freely.

The reality is that there will be winners and losers whenever the Fed changes policy.  As a result, the central bank will always face criticism, no matter what the decision.  Perhaps the FOMC should open its next meeting by listening to “Garden Party” by Ricky Nelson[1] and heed the song’s wisdom that it’s impossible to please everyone.  You can find a vintage performance by Nelson here and the lyrics here.

Thank you for reading,

Mr. Market Commentator

[1]  For the uninitiated, Ricky Nelson was one of the top “teen idols” of the 1950s.  Like many rock-and-roll stars of the day, he had a squeaky clean image and rockabilly influenced pop songs.  In 1972, Ricky performed at a rock-and-roll revival in Madison Square Garden.  His hair was now shoulder-length and he wore bell-bottom pants and a purple velvet shirt.  Apparently, the crowd did not approve of his new image and booed him off the stage.  “Garden Party” was Ricky’s response.

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