What do we know about the Fed besides that it oversees the U.S. economy’s well-being and that we usually change the channel when it comes up in the news? If you don’t know, don’t worry! We’ll try to explain here.
Even though we may not think that the Fed’s actions affect us, it’s important to understand them when looking into our next investment opportunity. Because, in reality, the Fed actually affects our everyday lives.
But how?
One of the Federal Reserve’s most important jobs is to regulate the U.S. economy and act as a driving force to either slow it down to manage inflation or to speed it up to control recession. This impacts us because interest rates are ultimately what drives the amount of available cash in the economy.
For example, businesses are affected when people have less cash to spend because it usually pushes consumers to buy less or to find cheaper alternatives. This increases unemployment, given that businesses make less sales to consumers.
Contrarily, when inflation decreases, people have more cash to purchase goods and unemployment decreases because businesses need more hands to operate.
How the Fed works
The way the Fed manages inflation is by raising or lowering the Fed funds rate, which is the interest rate at which banks lend each other money. The reason why banks lend each other money is because they have to meet the Federal Reserve requirement: a minimum amount of money they have to keep at the end of each day to ensure their operations stay afloat.
While the Fed can’t impose the interest rate on banks, it uses open market operations to drive the rate to the number it wants. For example, if the Federal Reserve wants to lower the interest rate to speed up the economy, it buys securities from its member banks, injecting them with cash and making it easier for banks to lend and borrow money to maintain their reserves.
This way, banks also have more cash available to lend to consumers, so their interest rates drop and people have more money to spend in the economy.
Contrarily, if the Fed wants to raise interest rates to slow down the economy, it sells securities to banks. This means banks have less cash to lend, making it more expensive for other banks to borrow to maintain their reserve requirements. As a result, banks raise the interest rates on loans and credit cards for consumers.
This way, consumers have less access to credit and they spend less, forcing businesses to lower their prices and contracting the economy to control inflation.
How has the Fed funds rate behaved recently?
In order to drive these operations, the FED’s experts are constantly monitoring and analyzing the U.S. economy. However, there are conflicting opinions on how they should act this year and many people have criticized the four rate increases that took place in 2018.
It is true that the Fed funds rate has been abnormally low since the 2008 financial crisis, when it was lowered to nearly zero – 0.07% (you can learn more about historical interest rates here) – until December 2015 to boost the economy and bring it out of the recession.
In a healthy economy, the rate should be higher and the Fed shouldn’t have to inject as much cash. The rate has been increasing since 2015 and is currently at 2.40%. Nonetheless, some are skeptical about the Fed continuing to raise the rate because it signifies an optimistic outlook on the economy.
What will the FED’s actions look like in 2019?
It is no secret that with Trump’s politics, the U.S. economy faces uncertainty. The war on imports through his protectionist measures has had some negative impacts, including higher costs for U.S. consumers and retaliations from other countries, hurting U.S. exports like agricultural products.
It seems that consumers agree that these measures are not the best prognostic for this upcoming year. On the upside, the unemployment rate continues at a 50-year low and is expected to drop even more, while inflation has remained modest.
It seems as though the Fed continues to try to be optimistic and will raise interest rates even further in 2019. They had initially announced three hikes planned for 2019, but in December they scaled down to two. Could this be a sign of the Fed acknowledging uncertainty to come?
It seems as if the markets feel this way, with stocks plummeting once more when they announced a rate increase last December 19.
Nonetheless, the Fed bases its decisions on data and hard-fact studies, so they are not likely to change their approach based on consumer reactions. According to Simon Moore at Forbes, some of the important factors expected to be monitored closely this year are China, housing, energy, and agriculture. China is the world’s fastest growing economy and any retaliations caused by the trade tensions with the U.S. could have an impact on the U.S. economy.
Additionally, the housing market is always affected by rising interest rates, as homebuyers are discouraged by higher mortgage rates. The energy sector is one to watch as well, given that there was talk about raising investment in energy to increase U.S. oil output. Finally, the agricultural sector is one at risk due to the recent trade war.
So what does this mean for the stock market in 2019?
Last year, the FED’s actions were negative for the stock market, as their announcements and rate increases, in part, caused stocks to decrease, contributing to the worst December since 1931. However, it seems the Fed will have a more conservative approach this year.
At an interview at the Economic Club of Washington D.C, Federal Reserve Chairman Jerome Powell said that the Fed would adjust and react along the way, closely monitoring the economy and being “flexible” with their decisions based on the economy’s response. He also mentioned that the Fed is open to changing its forecast from two interest rate hikes to only one.
With this precedent, it looks like the stock market will not be as negatively affected by the FED’s decisions in 2019 as it was in 2018. With fewer interest rate hikes, the economy’s interest rate will not raise as much and consumers will likely have more dollars to spend.
