Buzz
The Federal Reserve frequently takes center stage in financial news, and yesterday was no exception. However, its announcements can often seem hard to understand. So, what exactly is the Fed, and why do so many people pay close attention to it? More importantly, how does it affect your financial situation?
In short, yes. Paying attention to the Fed gives you valuable insights into the current state of the economy, what might come next, and how it could impact your business, job, and investments. While it might sound complicated, grasping the basics can make a significant difference.
So, what exactly is the Fed?
The Federal Reserve (commonly referred to as 'The Fed') is not a government agency. While its Board of Governors is appointed by the U.S. President, it is owned by private banks and operates independently. It was created with the responsibility of managing the U.S. economy under three main objectives: maximizing employment, stabilizing prices, and moderating long-term interest rates.
Typically, when the Federal Reserve lowers interest rates, their goal is to boost economic activity. On the other hand, they tend to raise rates when they aim to cool down the economy.
The Federal Reserve's Objectives
The Fed controls interest rates through one of its committees, the FOMC (Federal Open Market Committee). The FOMC meets eight times a year, and after each meeting, they release a press statement that is widely seen as the most authoritative 'financial state of the union.'
This 'state of the union' report always makes the financial news. Major news outlets cover the chair's remarks and then begin to 'read between the lines' to interpret what the statement truly signifies.
Grasping what the Fed communicates and the reasoning behind it can help you navigate the commentary and news. Just as an airplane or ship relies on navigation points to reach its destination safely, the FOMC operates based on two key guidelines for its actions. It aims to:
Unemployment should be under 5%
Inflation should remain as close to 2% as possible
So, when you come across media reports about unemployment and inflation, these are the key figures to keep in mind: as we approach these goals, interest rates are likely to start increasing.
Additionally, they also monitor GDP (Gross Domestic Product) growth as a sign of overall economic well-being, along with the strength of the dollar in comparison to other global currencies.
Current Situation
We are currently at a significant moment in history: over the last three decades, interest rates have consistently decreased, as shown in the following chart of the Federal Funds Rate, which is the basis for all the interest rates we encounter, from savings accounts to mortgages and car loans:
As you can observe, this rate is hovering around zero—it can't go any lower. This is why many experts predict that the long-standing trend of decreasing interest rates will soon shift.
By the end of 2014, the unemployment rate was 5.7%: still not ideal, but improving. Inflation seemed to be approaching the 2% target, but the drop in oil prices caused it to fall back down. Since then, unemployment has further declined to 5.5% by the end of February, and some believe the Fed may consider this 'close enough.'
On March 18th, Janet Yellen (the current chair of the Federal Reserve) indicated that the Fed is unlikely to raise rates before the summer of 2015. However, if the economy continues to improve at this rate, we can expect the long-anticipated rate hike at one of the upcoming meetings (you can check the schedule here).
If economic growth (as measured by GDP) is too sluggish, the Fed won’t raise rates, as this could plunge the economy into a recession (defined as two consecutive quarters of negative GDP growth). GDP growth for 2014 ended at around 2%, which was on the lower side of acceptable. So far this year, it has decreased rather than increased, which is one of the primary reasons the Fed is hesitant to apply the brakes (i.e., raise rates).
How the Fed's Decisions Impact Your Finances
When the Fed eventually raises interest rates, there are a few things you can expect. First, the days of earning nothing on your savings account will slowly come to an end. (Yay!) It won't happen instantly, but you can anticipate higher returns on all interest-bearing investments.
Sadly, loans and other forms of debt will become more expensive once interest rates increase. (Boo!) So, try to eliminate as much debt as possible. If you have a variable-rate mortgage, now is the time to switch to a fixed-rate mortgage.
When interest rates rise, the market value of bonds and bond funds will decrease. The cash you receive quarterly from your current investments will remain the same, but bond values and interest rates move inversely: when one rises, the other falls. So, when you rebalance and sell some of your bond funds, expect a loss. On the flip side, as rates keep rising, you can expect higher returns on new investments soon.
On a larger scale, rate hikes often signal negative changes in the economy. It can start with a significant drop in the stock market, which then pushes the economy into a full-blown recession. You can see this pattern in the chart above—the shaded gray bars mark recessions, and you can clearly see how rising interest rates precede recessions. We can never predict exactly when the next crash will happen, but the interest rate hike often marks the official beginning of the "crash watch." (This is why so many people are closely watching the Fed these days.)
If you own a business, now is not the right time to expand. Fixed overhead and debt are the two biggest business threats in a recession. Starting a new business now is, more likely than not, a bad idea for the same reasons. If you're confident your new business is recession-proof, go ahead, but don’t say you haven’t been warned.
If you're ready, a recession doesn't have to be a bad thing. In fact, it's one of the best periods in the economy, as everything becomes more affordable, from investments to vacations. As someone once said: winter isn't so tough if you're in the Bahamas. The key is being prepared. Knowledge is power, and by paying attention to the Fed's signals, you will always be ahead of the game.
