With the Federal Reserve once again in the news, it is worth discussing this important organization and its role in the economy and investing. The Federal Reserve System (or more simply the “Fed”) is the central bank of the United States. The overall system is comprised of 12 regional Federal Reserve Banks that support the needs of local communities in their region. On a day to day basis the Fed is responsible for the integrity of the nation’s banking system: supervising member banks, lending to banks, providing key services like interbank transactions, and examining banks to ensure compliance with consumer protection and lending laws.
Of course, the bank is often in the news for its less mundane role. The Fed is responsible for monetary policy, managing the supply of dollars in the banking system as well as key interest rates that have an important impact on the economy. You will often read that “The Fed has decided to raise rates” or “The Fed has decided to lower rates”. Because of this terminology a common misperception is that the Fed controls all interest rates. It does not. However, it does target certain key banking interest rates and bank reserve requirements that will impact the interest rates that banks charge. The most commonly quoted rate targeted by the Fed is the Federal Funds Rate, the interest rate at which banks lend to one another, most often on an overnight basis. By raising the Fed Funds Rate the Fed increases the cost of borrowing which can slow the economy. Conversely, lowering the Fed Funds Rate can decrease the cost of borrowing and stimulate the economy.
So why wouldn’t the Fed simply keep rates low so the economy can grow at the fastest possible rate? To answer this question, it is important to remember that the Fed doesn’t control the economy, but instead impacts the economy by encouraging or discouraging borrowing. Keeping rates too low for too long can cause significant problems, like inflation or asset bubbles. On the other hand, raising rates too quickly or keeping rates high for too long can cause a recession. In practice there is a ‘ditch on either side of the road’ and therefore the Fed tries to find the balance between its goals of ‘maximum employment’ and ‘stable prices’.
The Fed’s job is made more difficult by the fact that there is so much out of its control and it takes so much time to see the impact of their decisions. The Federal Government, businesses, consumers, and even the broader global economy all can change the path of the U.S. economy. Meanwhile, it may take 6 months before the effects of an interest rate decision is felt in the economy. Some have likened the Fed’s job to steering a large ship with a small rudder. It takes time to turn the ship.
Since the market does react to changes in the Fed’s interest rate policy, it is important as an investor to pay attention to what the Fed does. Recently, the Fed has begun lowering rates in an attempt to stimulate the economy, but has already been criticized, most notably by President Trump, for keeping rates too high for too long and for not lowering rates fast enough. Only the future will tell whether the current course is correct. However, the Fed’s current path of lowering rates has calmed the market and is helping keep the current stock rally alive.