By Joe Delaney
We have been hearing for some time that interest rates were supposed to rise and yet they have not. You may have heard that interest rates are expected to rise faster under the new Federal Reserve Chairman, Jerome Powell, who will likely replace Janet Yellen in February 2018. (His confirmation is subject to Senate approval, but it is widely thought that Powell was a “safe” pick by President Trump on November 2nd).
While many of the implications of the federal funds rate are mostly of interest to economists and politicians, it is important to understand the potential effect on individual borrowers and investors like you.
What is the Fed?
The Federal Reserve System(a.k.a. “The Fed”) is the central bank of the United States. Their stated mission is to set monetary policies that are intended to do three things: maximize employment, keep prices of goods and services stable and keep financial markets stable as well.
How does it influence the economy?
The main tool in the Fed’s toolbox is control of the federal funds rate. If banks get nervous and slow lending, that makes it harder for individuals and businesses to get funding for lines of credit, inventory financing, etc. To avoid a recession – job losses, home foreclosures, etc. – the Fed lowers the federal funds rate, the cost of borrowing overnight from the Fed’s 12 regional central banks.
If banks are lending too much and there’s too much cash in the economy, it becomes less valuable and prices go up. To counteract this, the Fed does the opposite: it will raise the interest rate to slow inflation. The Fed hasn’t been too keen on doing that since the Great Recession. In fact, their policy of quantitative easing in the wake of the 2008 stock market crash is about as far as you can go in the other direction.
What is quantitative easing (QE)?
When slashing interest rates down to basically free money for banks doesn’t stimulate lending, how do you get money into the economy? QE was the answerfor the Fed and other world economies from 2009 through the third quarter of 2014. The idea was to purchase bonds from banks to put more cash in their reserves and encourage money to move in the system.
Many economists have debated QE’s effectiveness. While it seemed to contribute to a reduction in unemployment, its effects on other indicators of economic health have been mixed. It actually raised inflation expectations, for example, a natural consequence of flooding the economy with too much cash. What we know for sure is that the Fed now owns $3.5 trillion more in public debt than they did before 2009 (estimated to total approximately $4.5 trillion today). The next Fed Chair will have a sizeable balance sheet to deal with, and will need to decide how much debt to call in from U.S. banks and how fast.
Why does it matter that Jerome Powell is taking over the Fed?
It’s hard to say whether it will matter much. Janet Yellen has been extremely hesitant to raise rates since the Great Recession, and her successor has generally supported her policy decisions. At most, if Powell raises the federal funds rate a bit faster than Yellen would have, it won’t be much faster. He is not expected to offload debt too fast, either.
While Yellen is more of an economist, Powell comes from a legal, government and corporate America background. The latter has been more critical of Wall Street regulationsand he will have more power to loosen them as Fed Chair.
So, what are the implications for investors if rates rise a little faster, or if financial industry regulations are loosened? As so often happens with government policy changes, there tend to be winners and losers. While low interest rates tend to mean more borrowing and business growth, which can improve company stock values, it also means returns on pensions for people with fixed incomes remain low. Regulations are tricky because, while corporate America tends to shun them, too much deregulation can remove important protections for investors.
Bottom line, what does this mean for me?
If the Fed does its job perfectly, it will raise rates at just the right speed to fight inflation without discouraging lending, to keep money flowing through the economy. Stock prices will rise at a steady, predictable rate. Home prices will be at just the right values relative to family incomes.
That’s a fairy tale world, of course.
In reality, we don’t know exactly what effects monetary policy will have on us as individuals. Monetary policies like quantitative easing have had mixed results and probably aren’t going to solve all the economy’s problems alone. If Jerome Powell slashes regulations on Wall Street, it could just as easily add to market volatility as it could stimulate markets in a positive way.
That said, there’s no need to panic. While the federal government can help keep the markets steady from a thirty thousand-foot view, it does not have the answers to keeping your portfolio secure. No matter what the Fed does, always stick to the basics:
- Have a written investment plan you follow no matter how you’re feeling about the markets moving up or down.
- Maintain a globally diversified equity portfolio with some low-correlated alternative asset classes (a fancy way of saying don’t put all your eggs in one basket!) and fixed income appropriate to your needs.
- For your fixed income, set up a bond ladder (a schedule of bondsthat mature at regular intervals) positioned to handle the potential for rising interest rates in the future.
- Figure out how much risk you need to take and don’t exceed your risk tolerance.
All this comes not from becoming an expert on economics and U.S. monetary policy, but simply from making an appointment with your trusted financial advisor. If you’re ready to have that conversation, call Lifeguard Wealth today. We are here to help.
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