What Are “Interest Rates” Anyway?
The Fed announced yesterday (Wed Jan 26th 2022 ) during press conference that interest rates are going up. And now the stock market’s going down… but why?? What the heck does the Fed have to do with interest rates, anyway? 🤔
For the unacquainted who’ve seen us talking about the importance of the Fed for a year, our obsession with interest rates might seem like infatuation. 😍 But that’s because interest rates affect many aspects of life in a country, its economy, and its markets. Let’s examine why:
* The Federal Reserve controls the federal funds rate (this ‘interest rate’ JPow talks about), which is the target interest rate at which commercial banks can lend their reserves to each other. A bank’s reserves describe the cash that banks have to keep in actual vaults to make sure they have enough liquid money to satisfy a large withdrawal. The federal funds rate is important because it affects unemployment, economic growth, and inflation in the U.S. 🚨
* The federal funds rate affects other interest rates that you may be familiar with, such as interest rates on home or auto loans. 🚗 🏡Why does this relationship exist? Well, because the interest rate at which you have to pay back your car loan depends on the bank’s individual rate for you (this is known as the prime lending rate), and your individual rate is directly related to the federal funds rate.
* You probably heard yesterday that the Fed is going to ‘reduce its balance sheet’ and ‘raise rates.’ When the federal funds rate is low, it encourages people to invest or take out loans (because you have less interest to pay back.) That’s why the Fed lowered rates during the pandemic in an effort to incentivize people to participate in the economy in spite of lockdowns. The Fed also started buying bonds and other securities — ‘increasing the size of its balance sheet’ — in a process called quantitative easing to help lower interest rates.
* Although lowering rates and increasing asset purchases was an appropriate short-term monetary response to the pandemic-era economy, low rates and printing lots of money causes inflation in the long run, which is where we are now.
* So if raising rates helps combat inflation, why is the stock market reacting negatively? Because higher interest rates raise borrowing costs, disincentivize hiring, increase credit card rates, and generally slow down the economy (at least, temporarily.) And when the economy slows down, bonds become more appealing investments because they’re less risky — so investors are selling or switching to bonds to avoid losing money. 💡
At the end of the day, the Fed is reacting to inflation in a way that’s historically appropriate. The market just isn’t happy because, in the words of JPMorgan analyst David Stubbs, “What the market doesn’t like, is rapid changes in the monetary landscape.” 🤷
