Papale on The Fed

By Steve Papale

It’s spring here in the Midwest.  How do I know that you say?  Maybe the birds chirping?  Baseball has started ( this is our year Cub fans)?  The trees are filling in with leaves?  Well you could say those are certainly signs of spring.  But for me it’s one thing – weeds have sprung up all over the yard.  Time to get out the weed killer – that would be my 2 boys going around and pulling them.  I love spring.

It seems these days we are constantly on Fed watch.  I remember years ago when Alan Greenspan was the chairman, Fed watchers as they’re called, could supposedly predict what the policy decision was based on appearance of his briefcase.  Was never sure how that worked but the obsession with the Fed continues on today.

The role of the Fed basically is to manage the economy through avoidance of booms or busts.  This is accomplished through monetary policy via short term interest rates called the Fed Fund Rate.  The Fed Fund Rate is simply the rate of interest banks charge each other for overnight loans.  Banks have certain rules for how much money they need in reserve and when they can’t meet it they can borrow short term from other banks.  The control of this interest rate ripples through the entire interest rate market, causing borrow costs to be more or less, depending on the rates.

For example, if the Fed is concerned the economy is moving too fast as evidenced by higher levels of inflation, they might choose to raise interest rates.  By doing this business have to pay more to borrow money for business operations and expansion. This higher cost will either curtail businesses from expansion or the business will pass the higher costs onto customers.  These higher prices will in theory cause demand to fall which over time should lower prices.  If higher prices can’t be passed onto customers, corporate profits will be squeezed and companies will at some point scale back.

In addition, things like mortgages and auto loans are higher so the cost of home and auto ownership increases.  College loan rates go up so education costs are higher.  On the positive side, savers will get paid higher interest on their money.  All these higher costs ripple through the economy causing less disposable dollars to be available, lower overall demand and hence slowing the economy.

One other factor regarding interest rate pegging by the Fed – they can only control short term rates.  The farther out rates are the less correlation they have to the Fed’s actions.  For example, if the market expects higher inflation a year or two down the road but short rates are low, the long end of the curve may reflect higher rates even before the Fed takes action.  This is simply the result of market forces.  So while the Fed can have a big impact on rates, at the end of the day the market will respond to influences and factors it perceives.

 

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