Monetary Policy Via Interest Rates

Tomorrow is Fed day! Tomorrow Janet Yellen will announce whether the Federal Open Market Committee (FOMC) will continue to raise the current short term interest rates, or maintain the status quo. Here is a little primer to understand what the Fed is trying to do and what it might mean for you.

For roughly the past decade, when it came to listening to all of the banter about the Fed changing interest rates, it was only in one direction – down. Since 2008 the Fed Funds rate has been near zero. This is the rate that banks use to loan reserve balances between themselves. With this rate established by the Federal Reserve, it impacts the rates at which banking institutions will then charge to lend out money to businesses and consumers.

Here is what the Fed Funds rate has been over the last decade:

Source: The Federal Reserve Bank of St. Louis

Source: The Federal Reserve Bank of St. Louis

Now there is a lot of concern and discussion in regards as to when the Fed is going to start raising interest rates. This begs the questions: What does this mean and why should I care? The mandate of the Federal Reserve is to control the balance between employment rates and inflation rates. By setting short term interest rates, the Fed can try to control the flow of money in the economy. Using interest rates as a tool to effect monetary policy, in the short term this can influence inflation, demand for goods and services, and even employment rates.

The thought process is this: with lower short term interest rates, since it is less expensive to borrow money, people consume more goods and services, and companies invest to expand their businesses. Companies then respond to that increase in demand by hiring more employees and increasing production. So, the monetary policy of lowering interest rates can have an impact on employment and production.

With companies looking to hire more employees coupled with consumer demand for more products and services, there tends to be an increase in wages as well as the cost of goods and services. This is known as inflation. When inflation rates get above the target rates set by the Fed, then the Fed can raise interest rates to combat inflation. This will then have the inverse effect of lower interest rates. And the cycle goes on as the Fed continually tries to strike that delicate balance between employment rates and inflation rates.

There are a couple of terms that are commonly used to describe the behavior of the Fed when it lowers and raises interest rates. When the Fed lowers interest rates, since they are making access to money easier, this is known as quantitative easing. When the Fed has a policy of low interest rates it is referred to as “dovish”, which roughly translates as they are at peace with inflation rates and are comfortable that inflation is not out of control. When the Fed turns “hawkish”, they are looking to raise interest rate which tightens the money supply as both businesses and consumers will find it more difficult to borrow money. A hawkish policy is the Feds means to combat high inflation rates.

The Federal Reserve is always looking at different economic indicators to guide their decisions on monetary policy. Every month the Fed closely monitors employment rates as tracked by the U.S. Department of Labor. They also monitor the Producer Price Index (PPI) and Consumer Price Index (CPI) to keep a watchful eye on inflation. It is thru these statistics and then the ensuing decisions on interest rates (which then impacts the money supply), that the Federal Reserve impacts the overall economy. This is why investors (as well as everyone else) should care what the Fed does. After all, we are all inherently tied to the health of our shared economy as we are all either producers, consumers, or both!

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