Will they, or won’t they? June unemployment numbers looked better and fears of an imminent economic downturn are easing, seeming to dampen expectations that the Federal Reserve will cut interest rates at the next meeting, which will be on July 30 and 31. The Fed leadership says a healthy economy does not need the stimulus of a lower rate and they are inclined to keep the fed funds rate where it is, between 2.25 and 2.50 percent, which is already historically low.
However, the agency and its chair Jerome Powell are under pressure from political pundits and the Trump administration to make a deep cut at their July meeting. The president has called the Fed the “most difficult problem” facing the United States economy. Trump has called Powell “loco” and regularly threatens to fire or at least demote him, which would cause legal and financial complications, to say the least. (Powell, in testimony to a House Financial Services committee on July 10 said he would not comply with such a presidential action.)
The president’s recent nomination of economic scholar Judy Shelton (a rate-cut skeptic turned advocate) and economist Christopher Waller (research director at the Federal Reserve Bank of St. Louis and a proponent of Fed independence) made headlines, while the nomination of Shelton, an advocate of returning to the gold standard, caused an increased bump in already rising gold prices. Trump appointed three of the five current sitting governors, as well as Powell, but his last four nominees for the remaining two vacant spots failed to get through Senate confirmation, significantly facing opposition from the majority Republicans.
Meanwhile, the Fed Chair Powell indicated that the effects of the trade war and Trump’s tariffs may push the Fed to cut rates anyway to balance any economic slowdown, though this action may not take place before the Fed’s scheduled meeting in September. “It appears that uncertainties around trade tensions and concerns about the strength of the global economy continue to weigh on the U.S. economic outlook,” Powell said in prepared remarks to the House committee on July 10. He also reiterated the Fed’s intention to “act as appropriate to sustain the expansion.”
In addition to all this, Powell simply using the word patience in a December 2018 speech caused turmoil in the financial world; though, when he took that word out in a June 2019 address and said that the Fed would be “watching,” things calmed down. As a result, each meeting has ratcheted up the suspense so that the agency’s next move resembles a blockbuster thriller.
But many of those following the drama may not really know exactly what the Fed is or how it operates. This may help you enjoy (or suffer through) the drama on a deeper level.
How the nation’s money is managed
The Federal Reserve System is the central bank of the United States. It provides the country with a safe, flexible, and stable monetary and financial system. The Fed system is composed of a Board of Governors, which is the central governmental agency in Washington, D.C., and 12 regional Federal Reserve Banks in major cities throughout the United States. Before that, the United States was the only major financial power without a central bank.
The Fed operates three wholesale payment systems: the Fedwire Funds Service, the Fedwire Securities Service, and the National Settlement Service. It performs five general functions to promote the effective operation of the U.S. economy and, more generally, the public interest.
The Federal Reserve:
• conducts the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy;
• promotes the stability of the financial system and seeks to minimize and contain systemic risks through active monitoring and engagement in the U.S. and abroad;
• promotes the safety and soundness of individual financial institutions and monitors their impact on the financial system as a whole;
• fosters payment and settlement system safety and efficiency through services to the banking industry and the U.S. government that facilitate U.S.-dollar transactions and payments;
• promotes consumer protection and community development through consumer-focused supervision and examination, research and analysis of emerging consumer issues and trends, community economic development activities, and the administration of consumer laws and regulations.
The Fed has broad power to act to ensure financial stability, and it is the primary regulator of banks that are members of the Federal Reserve System. It acts as the lender of last resort to member institutions who have no place else to borrow.
The Fed’s income comes primarily from the interest on government securities that it has acquired through open market operations. Other sources of income include the interest on foreign currency investments held by the Federal Reserve System; fees received for services provided to depository institutions, such as check clearing, funds transfers, and automated clearinghouse operations; and interest on loans to depository institutions. After paying its expenses, the Federal Reserve turns the rest of its earnings over to the U.S. Treasury.
The Board of Governors of the Fed are nominated by the president, must be confirmed by the Senate, and serve fourteen-year terms if confirmed. A member who has served a full term may not be nominated again. One term begins every two years, on February 1 of even-numbered years. The chair of the Board of Governors, nominated by the president from among the board, is the chief of the Fed and serves a four-year term. No member of the Board of Governors can be an officer or director of any bank, banking institution, trust company, or Federal Reserve bank or hold stock in any bank, banking institution, or trust company.
Among the responsibilities of the Board of Governors are guiding monetary policy action, analyzing domestic and international economic and financial conditions, and leading committees that study current issues, such as consumer banking laws and electronic commerce. The Board also exercises broad supervisory control over the financial services industry, administers certain consumer protection regulations, and oversees the nation’s payments system. The Board oversees the activities of Reserve Banks, approving the appointments of their presidents and some members of their boards of directors. The Board sets reserve requirements for depository institutions and approves changes in discount rates recommended by Reserve Banks.
The decisions of the Fed do not have to be ratified by the president. The Fed receives no funding from Congress. However, the Fed is subject to oversight by Congress, which aims to ensure it achieves the economic objectives of maximum employment and stable prices over the long term. The Fed chair must submit a semi-annual report on monetary policy to Congress.
Who sets the rate?
The Federal Open Market Committee (FOMC) is the Fed’s monetary-policy-making body and manages the country’s money supply. It is made up of the seven members of the Fed’s board of governors, the president of the New York Fed, and four of the remaining 11 regional Fed presidents. The FOMC meets eight times a year for two days to set the federal funds rate. The next two FOMC meetings are scheduled for July 30 and September 17.
The federal funds rate is one of the most important interest rates in the U.S. economy since it affects monetary and financial conditions, which in turn have a bearing on critical aspects of the broader economy including employment, growth, and inflation. The federal funds rate refers to the interest rate that banks charge other banks for lending them money from their reserve balances on an overnight basis. By law, banks must maintain a reserve equal to a certain percentage of their deposits in an account at a Federal Reserve bank. Any money in their reserve that exceeds the required level is available for lending to other banks that might have a shortfall. The interest rates the lending bank can charge is the federal funds rate or “fed funds rate.”
At its meetings, the FOMC adjusts the target for the overnight federal funds rate, which controls short-term interest rates, based on its view of the strength of the economy. When it wants to stimulate the economy, it reduces the target rate. The lower the rates, the more people are willing to borrow money to make big purchases. When consumers pay less interest, this gives them more money to spend, which can cause a ripple effect through the economy.
How rates work
Businesses and farmers also benefit from lower rates, as this encourages them to make more purchases due to the low cost of borrowing. Conversely, the FOMC raises the federal funds rate to decrease spending and slow the economy. The federal funds rate also influences short-term interest rates, albeit indirectly, for everything from home and auto loans to credit cards, as lenders often set their rates based on the prime lending rate. The prime rate is the rate banks charge their most creditworthy borrowers and is influenced by the federal funds rate, as well.
The primary justification for an independent Federal Reserve is the need to insulate it from short-term political pressures. Without a degree of autonomy, the Fed could be influenced by election-focused politicians into enacting an excessively expansionary monetary policy to lower unemployment in the short-term. This could lead to high inflation and fail to control unemployment over the long term.
Higher market interest rates can also create a “buyers’ boycott” of the stock market, as more attractive investment opportunities emerge. For example, Treasury bonds are considered a “risk-free” asset. If rates rise to the point that an investor can get a “risk-free” rate of 6 percent on a Treasury bond, many investors will choose Treasury bonds over the stock market. While stocks have a higher long-term average return, they are also volatile and carry much higher risks than Treasury bonds. Fewer buyers mean less money to push up stock prices.
Fed chair Powell said at a news conference after the Fed’s two-day meeting in June that officials were “watching” economic developments to gauge whether and when action on rates was warranted. He also noted that wages are rising, but not at a pace that would provide much impetus to inflation, and that weaker global growth may continue to hold inflation down around the world.
A growing number of officials on the Fed’s policymaking committee expect to lower rates minimally before the end of the year amid continuing trade tensions and slowing global economic growth. The decision to lean toward a rate cut is a significant shift for the central bank, which raised rates four times in 2018 and adopted a “patient” stance this year, although the patient stance was dropped from its policy statement. Instead, the policy statement now states that the Fed will “act as appropriate” to sustain the economic expansion. Officials clearly see their next move as an effort to avert economic softening, rather than the start of a rate-cutting cycle that would take the policy setting back toward near zero.
An unhealthy relationship
The next FOMC meeting is July 30 and 31, following another month of economic numbers and several weeks of second-quarter corporate earnings, as well as the second-quarter GDP numbers, set for release on July 26.
In the current environment, short-term bonds have a higher yield than longer-term bonds. This is an inverted yield curve. Normally we would expect that investors would receive higher yields for taking longer duration bonds. After all, there is a risk to longer durations and investors want to be compensated for it. So, if we plot yields against time, we would see that yields rise. That only makes sense; unless you get a higher yield, why would you take additional duration risk?
History shows that this isn’t a healthy relationship, since the U.S. economy and stock market are always strongest when longer-term yields are above short-term yields. Moreover, history shows that whenever the fed funds rate gets above the 10-year yield and stays above it for an extended period, the result is usually a slowing economy and sometimes even a bear market in equities.
Another way to go
There is another option for the Fed to add further monetary stimulus besides cutting rates. That option is for the Fed to end the reduction of its balance sheet ahead of schedule. The Fed amassed a whopping $4.5 trillion in treasury and mortgage-backed securities during and after the financial crisis. The move was part of the Fed’s effort to stimulate the economy through a massive injection of cash. This was known as quantitative easing. In October 2017, the central bank began to run off those assets on a monthly basis, as it appeared the economy was on better footing. This process of running off the assets is known as quantitative tightening. Ending the process ahead of schedule would keep monetary conditions looser as more liquidity would remain in the system. This would also help the central bank fend off an economic slowdown.
With ongoing trade and tariff uncertainty, it is very difficult for businesses to make long-term hiring and capital expenditure decisions. If this drag continues and trade tensions escalate in the coming days, weeks, and months, it would not be surprising to see the economic situation continue to deteriorate despite a drop in rates by the Fed. Therefore, we must remain open to a wide range of future outcomes, from wildly bullish to wildly bearish.
If you have any questions about the Federal Reserve, please call us at 610-793-1001 and we will help you answer any questions.
Disclaimer:
While this article may concern an area of investing or investment strategy in which we supply advice to clients, this document is not intended to constitute a complete description of our investment services and is for informational purposes only. It is in no way a solicitation or an offer to sell securities or investment advisory services. Any statements regarding market or other financial information is obtained from sources which we and/or our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information.
Past performance should not be taken as an indicator or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. As with any investment strategy or portion thereof, there is potential for profit as well as the possibility of loss. The price, value of and income from investments mentioned in this report (if any) can fall as well as rise. To the extent that any financial projections are contained herein, such projections are dependent on the occurrence of future events, which cannot be predicted or assumed; therefore, the actual results achieved during the projection period, if applicable, may vary materially from the projections.