Understanding the Fed and interest rates

E*TRADE Securities

12/16/20

When investors talk about the markets, one topic often plays a leading role: the Fed and the interest rates it manages. It's important to understand why the Fed does what it does and how interest rates may affect your investment portfolio.

What we call "the Fed" is actually the Federal Reserve System, the central bank of the United States. (It’s not technically a government agency, but it’s controlled by one that reports to the U.S. Congress.) The Fed’s primary mission is to manage inflation while also promoting maximum employment. It also facilitates and supervises the U.S. banking system and works to maintain the stability of financial markets.

To accomplish its missions, the Fed has a range of powers, but arguably the most important is its authority to set the Federal funds rate, the key interest rate in the U.S. economy. The Fed can also influence the economy and markets with its vast powers to lend money and to buy and sell securities, especially bonds.

How interest rates work

The Fed funds rate is the interest rate that depository institutions like banks charge each other for overnight loans. The Fed effectively controls this rate and can push it up or down.

It's the key interest rate in the U.S. economy because all other interest rates follow from it. For example, banks use it as a basis for their “prime” interest rate—the rate they charge their best customers for loans. The prime rate is often set three percentage points above the Fed funds rate. If the Fed funds rate goes up, the prime rate also goes up, along with many other interest rates. This relationship applies to all interest rates, whether you're borrowing money to expand a business or buy a home, or whether you're earning interest in a savings account or from a bond.

Why the Fed raises and lowers interest rates

Generally speaking, the Fed raises interest rates to reduce inflation, or keep it in check, when it threatens to go above a specified annual rate, currently about 2%. Higher interest rates increase borrowing costs and tend to slow economic growth, which puts a brake on inflation.

On the other hand, the Fed typically lowers interest rates to stimulate economic growth and thus help reduce unemployment. Lower borrowing costs for businesses and consumers tends to boost the economy and job creation along with it.

The twin goals of controlling inflation and maximizing employment have to be balanced against each other, which is why the Fed moves interest rates higher and lower in response to economic conditions.

It's also important to know that the Fed can use additional tools alongside interest rates to carry out its dual mission, and those may also have an impact on markets. Beginning in 2008, the Fed used large-scale purchases of Treasury securities, a process called Quantitative Easing, to try to keep interest rates low and support economic growth.

Similarly, in response to economic damage related to the COVID-19 pandemic in 2020, the Fed started a program to buy corporate bonds. The central bank took this unprecedented step in order to support the corporate bond market and provide credit to companies that may need it, again with the goal of bolstering the economy and lowering unemployment. As a further step to support economic recovery in the wake of the pandemic, in September 2020 the Fed announced its intention to keep the Fed fund rates at or near zero for an extended period—perhaps as long as 2-3 years.

The twin goals of controlling inflation and maximizing employment have to be balanced against each other, which is why the Fed moves interest rates higher and lower in response to economic conditions.

How interest rates affect investors and savers

As mentioned above, interest rates of all kinds follow from the Fed funds rate, so it essentially determines the cost of borrowing—for home and auto loans, for example, and even credit card rates. It also impacts investors and traders who use margin, since margin is a form of borrowing. Higher interest rates will translate to higher margin rates.

On the other side of that coin, the Fed funds rate impacts the rate of interest a financial institution will pay savers for money they deposit in something like a savings account or a certificate of deposit. Simply put, savings will earn less when interest rates are low and more when interest rates are high.

The effects of interest rates on investments such as stocks and bonds can be more complex. First, investors should understand that bond yields and prices move in opposite directions. When the Fed lowers interest rates, bond yields fall and their prices on the secondary market rise as demand for previously issued bonds goes up. This means that falling interest rates can boost the value of bonds in a portfolio and rising rates can lower their value. Of course, interest earned is also an important component of the overall return of a bond portfolio, and that may change as money from maturing bonds is reinvested in newer bonds over time. If the newer bonds have higher yields, the portfolio will earn more interest; if yields on newer bonds are lower, the portfolio will earn less.

For stocks, the impact of interest rates is less direct. But generally speaking, low or falling  interest rates  tend to boost stock prices. One reason is that investors often believe that lower interest rates—and thus lower borrowing costs—are good for companies and their profits. Not only can firms borrow more cheaply, but consumers may spend more because they can also use credit more cheaply. A second reason is that low yields make bonds a less attractive investment option, so investors, seeking better returns, may put more of their money into the stock market, increasing demand for equities.

Conversely, when interest rates are high or going up, that may be a drag on growth and corporate profits, and it may also cause some investors to move money out of stocks and into now higher-yielding bonds, reducing demand for equities. These factors can exert downward pressure on stock prices.

With those general trends stated, it's important to remember that there is no way to perfectly predict the direction of markets, so there's no guarantee they will move up or down in response to interest rate changes.

Reacting to changing interest rates

While changes in interest rates usually take some time—often many months—to affect the economy, markets typically react to them quickly.

We've already noted that interest rates and the stock market tend to move in opposite directions. That’s a very basic factor that every investor needs to keep in mind.

At a more granular level, some investors try to anticipate what sectors of the economy will benefit from an interest rate change. While rising rates may tend to lower corporate profits overall, they might benefit companies in the financial sector, for example, because those firms have the potential to earn more from the loans they make.

Savers should keep their savings goals and objectives in mind and ask themselves if interest rate changes affect those goals. For something like an emergency fund, the answer is often ‘no’—you need one regardless of interest rates. When interest rates are low, it may be worthwhile to look at refinancing loans like mortgages, and a strategy called CD Laddering—investing in CDs with staggered maturity dates—may lessen the impact of interest rate changes on some of your savings.

To sum it up, interest rates ripple through the economy in important ways, accelerating or slowing economic growth, indirectly influencing the profitability of companies, and affecting the unemployment rate and consumer spending, among other things. All of these in turn have an impact on the price of stocks. More directly, prevailing interest rates determine the return investors can expect from bonds and other fixed income investments. That's why investors and savers pay such close attention to what the Fed does and whether the core interest rate it controls—the Fed funds rate—is holding steady, moving up, or going down.

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