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CASE STUDIES

The Federal Reserve Interest Rates: How the Federal Interest Rates Are Determined and How it Affects your Portfolio

How Interest Rates Are Determined and How They Affect Your Portfolio

The Federal Reserve is responsible for maintaining full employment at a range between 4 to 5 percent. Concurrently keeping the inflation low. There are two types of interest rates that fed has to balance for continued economic growth. The discount rate and federal fund rate. This paper discusses these interest rates and explains how it impacts the overall economy.

Interest Rates  

The Federal Reserve is very influential in how it directs the interest rates. The fluctuations in the interest rates impact various levels of the economy differently. For instance, when the interest rates are low, capital is easier to acquire this results in higher economic growth. If left unchecked the result is too much money chasing too few goods, leading to inflation as businesses realize they can charge higher prices for goods and services.  

Here is how the Federal Reserve can influence the direction of interest rates:

  1. By raising or lowering the discount rate.

  2. By indirectly influencing the direction of the Federal funds rate.

The discount rate and the federal funds rate are both used by banks to maintain reserve requirements. The difference being, banks apply discount rates when borrowing from the Fed, and use the federal funds rate when borrowing from other banks.

Discount Rate - is a type of interest rate charged by banks when they borrow funds overnight directly from one of the Federal Reserve Banks.

The Federal Funds Rate – is a type of rate banks charge each other for overnight loans. Banks borrow from each other to meet the Fed’s requirement by keeping a certain percentage of assets in the form of cash on hand or be deposited in one of the Federal Reserve banks.

The main objective behind this type of lending is to establish a required ratio of reserves to deposits; an increase in this ratio means more cash needs to be kept in the vault at night, making it difficult (and expensive) for funds to be acquired. This means the money supply is tight. On the other hand, when the reserve requirement is lowered, the money supply is loosened, as less cash needs to be kept in the vault, making it easier to acquire capital.

The increasing and decreasing cost of acquiring funds is directly passed on to consumers as banks adjust their prime lending rate. Notably, the prime lending rates is not uniform. For instance, Bank of America has one lending rate, while the U.S. Bank has another lending rate. The Wall Street Journal places an integral role, reporting on the polling of nation’s thirty largest banks; when all twenty – three of those institutions have changed their prime rates, the WSJ reports on the published rates.

Current Federal Reserve Interest Rates and Why They Change

Recently, the Fed lowered the federal funds rate to 2.25%. The benchmark rate is a marked indicator of representing the current health of the economy. The fed fund rate is critical in determining the current economic outlook. This rate controls the short -term interest rates which include; bank prime rates, adjustable rates, and interest-only loans, and the credit card rates.

The 2008 recession caused the Fed to decrease its benchmark rate to 0.25%, which is equivalent to a zero. The zero-rate lasted till 2015. In 2015, the Fed increased the rate to 0.5 %. The Federal Open Market Committee (FOMC) raised the fund's rate a quarter-point to 2.5% on December 19, 2018.

In 2013, the Fed lowered its quantitative easing programs. This process was widely accepted as a massive expansion of the Fed’s open market operations tool. In 2017, fed still carried a $ 4 trillion debt from quantitative easing. In this context, quantitative easing refers to large scale asset purchases, whereby the central bank buys predetermined amounts of government bonds or other financial assets in order to inject liquidity directly into the economy. Late in 2017, it allowed the holdings to decline, by July 2019, this number dropped to $3.8 trillion, and the fed announced it would no longer reduce its holding.

 

Note: The lack of Fed rate hike means banks won’t pay higher interest on your savings, but they will also not charge you more on loans. The change affects both wages and consumerism.

The call for fed to balance its interest rates does impact the overall economy. Therefore, understanding how these interest rates affect individuals’ personal budget, and how to avoid further future financial mistakes is key. Here are few smart moves when taken will help mitigate and avoid future financial troubles.

Here are five precautionary steps to build wealth and avoid financial strains:

  1. Pay off any outstanding credit card debt. The interest rate will go up as the Fed raises rates. 

  2. Avoid locking into a three- or five-year CD. You'll miss out on the higher returns when the Fed raises rates again in 2019.

  3. Shop around to take advantage of the best rates on your savings accounts. Big banks raise their rates more slowly than smaller ones.

  4. Don't procrastinate if you need to buy appliances, furniture, or even a new car. Interest rates on those loans are going up. They'll only get higher over the next three years. The same is true if you need to refinance or buy a new house. Interest rates on adjustable-rate mortgages are going up now. They'll continue to do so over the next three years, so question your banker about what happens when the interest rates reset. They will be at a much higher level in three to five years. You might be better off with a fixed-rate mortgage.

  5. Talk to your financial advisor about reducing the number of bond funds you have. You should always have some bonds to keep a diversified portfolio. They're a good hedge against an economic crisis. But this isn't the right time to add a lot of bond funds. Stocks are a better investment as the fed continues to raise rates.

 

 

Preparing for the Next Recession: Better response is required towards Fiscal Policy

Executive Summary

There is a real possibility that the U.S. economy could slip into a recession sometime in the upcoming months. Current economic indicators point to an economy that is humming along nicely, and the unemployment rate is at an all-time low. This is the longest economic recovery on record, but it will not last forever, a recession will occur. We have not eliminated the business cycle.

Here are the factors shaking the grounds of a solid economy, and causing probable concerns of a looming recession. Firstly, President Trump's unprecedented move towards the execution of the trade war with China and other countries has increased uncertainty among businesses. Secondly, corporate investment is also softening, despite the big tax cut, assured by Mr. Trump to boost it. Coupled with central banks inability to stimulate growth. Lastly, an expected inward pressure by other countries could make the governments less effective at responding to an economic downturn.

During the Great Recession which started in late 2007, household wealth and jobs evaporated across the country, and in many parts of the world. The U.S. government responded with a mix of monetary policy and fiscal stimulus that stopped and reversed the decline. Furthermore, the fed placed less emphasis on fiscal policy.

The Recovery Act legislation was passed after we had been in recession for a year. If we don’t prepare for the recession, we may be hit with the same problem again. Recession will come and will be in the middle of the election season, unable to do anything about it, because we will have to wait for the next president to pass the bill. We need to avoid such scenarios at all cost.

We need a wide variety of policies, as recessions play out differently among various demographics and geographic areas. For instance, some states never really recovered from the 2001 recession, therefore we need a set of policies for people living in places slow to recover or who may have never experienced a recession before.

Automatic stabilizers are a starting point and not the endpoint. More emphasis must be placed on the design of automatic stabilizers. Automatic stabilizers should reach people of all geographic and demographic areas in times of hardship. Decision-makers must place increased effort in the functioning of automatic stabilizers.

More thoughtful and pragmatic approaches are required towards how we will respond towards the recession should it happen again. For instance, a fix in administrative complexities related to how cheques are processed is required. We want to think through these things ahead of time.

Pulling forward the prescribed policy recommendations policymakers should take action now and not wait for a recession. Understanding that one size does not fit all we need a wide variety of policies to target various geographic and demographic settings.

 

Introduction

There is a real possibility that the U.S. economy could slip into recession sometime in the upcoming months. Current economic indicators point to an economy that is humming along nicely, and the unemployment rate is at an all-time low. However, we are on the verge of this being the longest economic recovery on record Figure 1 [1]illustrates the current economic expansion being the longest in U.S. history.

This economic recovery will not last forever, and that recessions will happen. We have not eliminated the business cycle. Notably, when recessions happen it can be devasting for workers and families, and for the people that are hurt by the loss of unemployment. So, we need to start thinking in advance.

In good times fewer people are unemployed, because they are paying the unemployment taxes, meaning we are spending less and taxing more. On the contrary, when we run into a recession more people are unemployed and are collecting unemployment insurance, hence the government is spending more money.

Recent changes in longer-term interest rates started to take a plunge in July, indicating a shift in slower growth. Other contributing factors include interest rate cuts from the Federal Reserve, an elevated risk that the economy can slip into an outright contraction.

During the great recession, Federal Reserve faced constraints when the rates dropped to a zero. Unfortunately, tools used in the past were not perfect substitutes to cutting interest rates. So far, we have had seven recessions since 1970 the Fed cut interest rates by at least 5 percentage points. Currently, the fed fund rate is 2.25 %. According to the economist, the fed will not cut interest rates 5 percentage points next time we have a recession.

Cause for Concern leading to the next recession

Here are the contributing factors shaking the grounds of a solid economy and causing probable concerns of a looming recession. Firstly, President Trump's unprecedented move towards the execution of the trade war with China and other countries has increased uncertainty among businesses. Secondly, corporate investment is also softening, despite the big tax cut, assured by Mr. Trump to boost it. Coupled with central banks inability to stimulate growth. Lastly, an expected inward pressure by other countries could make the governments less effective at responding to an economic downturn.

Reminisce of the past recession are all related to false beliefs about market happenings. In 2001, the market held the belief that a technology boom would continue to fuel the economy, unfortunately, this belief was short-lived, resulting in information technology bubble burst.

In 2007, the market belief was positively reassuring that the housing market would never face a meltdown, again this belief was soon proven to be inaccurate. This time the belief holds that the economy will continue to grow more stable and interconnected over time and that trade, currency, and diplomatic relationships can be depended upon for continuous economic growth.

During the great recession, fiscal policy was overlooked, which means less emphasis was placed on fiscal policy, because we had to wait for the new administration to pass the bill. Furthermore, we lacked the political capital, and focus because so many other casualties were taking place in the back end.

This paper briefly discusses the role of fiscal policy and why we should get it right in times of recession, and why we should start acting now and not wait for a recession for the fiscal policy tools to work.

What was the government’s response to the Great Recession and how does it fit in to the model of discretionary vs. automatic response?

Early on the government started to reduce the interest rate and also send out automatic payments to individuals. The Recovery and Reinvestment Act was instrumental in changing the course of the great recession.

American Recovery and Reinvestment Act (ARRA) was implemented in 2009, right after President Obama was elected. The act was recognized as being the single largest piece of legislation passed in dollar terms, it was seen as a massive stimulus to the economy as it included a wide array of things from tax cuts to aid the states, and Medicaid payment assistance, and infrastructure investments, and ways to shore up automatic stabilizers. Hence, both discretionary and automatic stabilizers were used.

There was also the expansion of welfare program TANF, SNAP, and unemployment insurance, basically, we were able to utilize all the tools in the toolbox. Additionally, there were also some tax cuts on the payroll side. and continued support provided through unemployment insurance benefits overtime. Unfortunately, only a few attempts were made at job creation.

 

We are going to be faced with the same problem again, the recession will come and we will be in the middle of the election season, unable to do anything about it. We need to avoid such a scenario and prepare for the recession, diving deeper to prepare for the expected and the unexpected.

 

The timing of the ARRA placement was incorrect. President Obama had been in the office less than a month when this piece of legislation was passed. Admittedly, this piece of legislation was crafted under impromptu circumstances, and it was not passed after we had been in a recession for a year.

Role of Monetary and Fiscal Policy

Monetary policy was instrumental in cutting interest rates. Monetary policy has to do with measures the Federal Reserve takes towards the running of the economy, such as; changing interest that affect the money supply, borrowing and lending rates individuals face in the economy.

 Fed was cutting interest rates during the time of great recession. But fed was overlooking the fiscal policy, when it should have been giving more emphasis to fiscal policy. Fiscal policy in this context is defined as policies involving taxes and spending.

Fiscal policy boost during the latest expansion was weak. The fiscal boost emerging from combined fiscal actions are measured either through peak to peak over the entire business cycle, or more relevantly through the first three years of recession recovery. The peak to peak measure involves actions taken during the recession such as the Recovery Act. While the measure from the trough including the three years shows the fiscal stimulus aiding recovery from the recession.

The data from Figure 2 show the fiscal austerity’s drag on the growth soon after the official recession was over. The fiscal stimulus in the first three years of recovery was historically weak following the Great Recession it provided less than a tenth of the spur to spending indicating the 1960’s and early 2000’s recessions, and less than a fifth the fiscal boost provided after the 1980’s and 1990’s recessions.

The fiscal austerity in this context is quite striking given that the fed’s recession tool of lowering short term interest rates was not given much emphasis to aid recovery.

Figure 2

 

Figure 2 provides a summary measure of the total fiscal boost provided by changes in government consumption and investment spending, transfer payments, and taxes during and after recessions. This figure compares the business cycles of the 1960s, 1980s, 1990s, early 2000s, and late 2000s.

Policy Recommendations

 

We need a wide variety of policies, as recessions play out differently among various demographics and geographic areas. For instance, some states never really recovered from the 2001 recession, therefore we need a set of policies for people living in places slow to recover or who may have never experienced a recession before.

Automatic stabilizers are a starting point and not the endpoint. More emphasis must be placed on the design of automatic stabilizers. Automatic stabilizers should reach people of all geographic and demographic areas in times of hardship. Decision-makers must place increased effort in the functioning of automatic stabilizers.

More thoughtful and pragmatic approaches are required towards how we will respond to recession should it happen again. For instance, a fix in administrative complexities related to how cheques are processed is required. We want to think through these things ahead of time.

Pass the legislation and think through things ahead of time to avoid bad timings incurred by the previous legislation.

We should not wait for the unemployment rate to reach 7 % to start worrying about the recession. Also, if the unemployment rate is rising rapidly, from 4 to 4.5 % we are in trouble. Note the unemployment rate does not go up that quickly and then stops. The unemployment rate continues to rise. Therefore, we need to monitor the rising rates and apply the tools we already have in a variety of different ways. There is no need to create new tools. We need to learn how to apply the same tools in a variety of different ways aiming for them to be more effective should and when the next recession strike

 

Conclusion

 

Pulling forward the prescribed policy recommendations policymakers should take action now and not wait for the recession to strike. Understanding that one size does not fit all we need a wide variety of policies to target various geographic and demographic settings.

Automatic stabilizers such as SNAP, and TANF is targeted at places with higher unemployment. Notably, families of minority ethnicities tend to be harder hit by unemployment, whatever the unemployment rate is for majority populations is double that for minority populations. This fact has proven to be true for long as the unemployment rate has been measured. Therefore, it is incumbent upon us to think hard about our fiscal policy responses when we have face economic downturns.