There tends to be a lot of confusion when it comes to the Federal Reserve and interest rates. It makes sense, too. Monetary policy can be confusing. But interest rates are a critical part of how we think about financial planning. To that end, we want to walk through, at a high level, how the Federal Reserve influences interest rates. From there, we’ll go behind some of the headlines you may encounter and how all of this may (or may not) affect your portfolio and financial plan.
A bit about banking
To understand how the Federal Reserve influences rates, it’s important to understand how banks work, at least at a high level.
Banks are required by law to end each day with a certain amount of customer money on hand, or in reserve. Because banks don’t generate revenue on their reserves, they try to keep as close to the minimum as possible. That means they sometimes dip below the required amount.
To remedy this, banks lend money amongst themselves in the form of overnight loans. The banks charge each other interest on these overnight loans, and the Federal Reserve sets a target for what this rate should be, known as the federal funds rate. It bases this target rate, known as the federal funds rate, on its assessment of the economy. Starting around the Financial Crisis, the Fed started sharing these economic assessments and forecasting potential changes to the federal funds rate in advance, which we’ll talk about more later on.
When the federal funds rate increases, it’s more expensive for banks to borrow money, so in general, they try to borrow less. That means keeping more money in reserve. For banks to lend and risk paying a higher rate amongst themselves, they need more incentive. That incentive comes in the form of higher interest rates for clients and consumers.
The converse is also true. When the federal funds rate goes down, banks don’t have to worry as much about keeping cash on hand. They’re more inclined to lend money to consumers, and they tend to offer better rates to borrowers.
The inflation effect
To better understand how the Fed thinks about interest rates, it’s important to remember the central bank’s purpose. The Federal Reserve has a dual mandate: maximum employment and stable prices. In other words, keep inflation in check while keeping Americans employed.
While the Fed also looks at overall economic trends (like GDP) and market factors (geopolitical risk, stock and commodity prices, how other countries are thinking about rates), they do so as part of their mandate to monitor inflation and jobs.
For years following the Great Recession, the Fed focused largely on jobs. Since lower interest rates make it easier for companies to borrow money, the thinking is that low rates mean companies will have more cash to use to hire employees.
Low rates don’t exist in a vacuum, however. They’re often paired with other forms of stimulus (during the Financial Crisis this was quantitative easing; during COVID-19, it was stimulus checks from the government). These stimulus measures tend to involve printing money in some capacity, and increasing the money supply can lead to inflation.
Economists have been warning about inflation since the Fed started more aggressive stimulus measures during the Financial Crisis, but for more than a decade, those concerns were largely hypothetical. Despite the ongoing low-rate environment, government data showed prices increasing at a fairly standard rate — around 2-3% per year — until COVID-19.
The pandemic led to big shifts in the global economy, from commodity prices to changes in international commerce. Inflation moved quickly from a hypothetical discussion among economists to a real concern for regular people. At first, the Fed assumed signs of inflation were a temporary result of the pandemic (the word they use is “transitory”). However, their thinking changed in 2022: The Federal Reserve forecasted several rate hikes during the year.
How rates affect investments
Changes to interest rates have the potential to affect all investments, but let’s focus very broadly on stocks and bonds. In general, when the Fed increases interest rates, it makes it harder for companies to borrow money. The logic goes that when borrowing costs more, companies borrow less, and have less money on hand to invest in growth and generate profits. For this reason, investors may sell stocks when rates go up.
In the past, this selling happened when the rate hike happened. However, as the Fed begins to share more of its thinking and forecast more of its moves, some traders and investors try to get ahead of the changes by selling in advance. The link between the rate change and stock market reaction may not be immediately clear, which can be confusing for investors following headlines about the Fed and markets.
When it comes to bonds, higher rates tend to mean lower bond prices. If new bonds are issued with higher (market) rates, then existing bonds (with lower rates) need to trade at a discount. But interest rates aren’t the only thing that affect bond prices.
Bonds, particularly U.S. treasuries, are considered one of the safest investments, since the U.S. government has never defaulted on its debt. Because of that, investors often buy treasuries in times of economic uncertainty, which can drive prices up. In general, we recommend looking at the total return of a fixed income investment — considering both price and yield.
Remember, these complexities are one of the reasons you work with a financial planner. We follow the different factors affecting your portfolio and make adjustments accordingly. If you do want to dig in, though, we tend to recap the various factors we’re watching in our monthly market updates. The January 2022 and February 2022 updates can both provide some real-world examples and context to the trends we discussed here.
Article is intended to be educational in nature and should not be considered investment advice.
