If you’ve ever learnt to ride a bike, you probably did so with the help of training wheels. You wheeled around the block, little legs pumping away, feeling safe in the knowledge that those additional tires had your back – supporting you as you made your way.
Then it was time to remove the training wheels, and that was pretty scary, and the first unsupported ride was all over the place, like a drunk trying to walk a straight line.
That’s basically what’s happening with the stock market and the Federal Reserve System. Informally called the Fed, the central banking system of the U.S. had kept interest rates really low for a really long time – which drove prices up.
But they kept warning us that they would raise rates…………eventually.
They said they would do it. Then they postponed it. The stock market kept rising.
That pattern repeated itself for a while, but the rate rise seemed inevitable.
Things kept happening. We had the oil crash in 2014, and the China stock sell-off this year and investors started getting kind of nervous. Would they raise rates even in the midst of this global economic uncertainty?
Investors worried that The Fed were going to take the training wheels off the stock market, and if they did would the market come crashing to the ground? This fear, combined with the fact that people were unsure about oil and China meant that the markets were seeing increased volatility – which is when stock prices are swinging wildly in either direction.
Investors got their wish, when the Fed, ending weeks of speculation, decided to keep interest rates unchanged for the time being. The reason cited: low inflation.
What is the Federal Reserve?
The Fed is the central bank and purveyor of money policy of the United States. You know how you and I have banks who consider us clients and keep our money safe? Well, those banks have a similar relationship with the Central Bank of the United States of America, a.k.a the Federal Reserve.
The Fed has the responsibility of making sure that the country is as close to full employment as possible – keeping prices stable and moderating inflation.
They do this using monetary policy.
Monetary policy is the process by which the Fed controls the supply of money in the country, increasing or decreasing it as they wish. Monetary policy also includes targeting inflation rates and setting interest rates.
First of all, what interest rate are we talking about? And secondly – how does setting an interest rate drive up stock up prices and help control the money supply?
There are so. Many. Interest rates. You’ve got an interest rate in your savings account. There are mortgage rates, insurance rates, and even credit-card interest rates. So which interest rate are we going on about?
The Fed funds rate. This is the interest rate at which banks can lend reserves to each other, and the rate at which banks can borrow money from the FED for short periods of time.
How Did We Get Here?
Imagine you’re a bank. By law, you’re required to hold a certain percentage of the money you take in from your clients – this is known as the reserve requirement. Banks are required to do this so that enough people who need access to their money will have it.
If you dip below your reserve requirement, you can supplement your stocks of cash by borrowing money from the government. However, it’ll cost you to do that. That cost takes the form of the Fed funds rate, and it’s been in the 0-0.25% range for the last 7 years.
What happens when interest rates are that low for an extended amount of time?
Saying interest rates are low is another way of saying that money is cheap. If you’re a bank, it’s true that you have lots of money – in the form of client deposits and the like. But you don’t want that money just sitting around collecting dust (like the treadmill you bought last summer).
You’d want to employ as much of that capital as possible, so you can earn as much money as you can. Makes sense. When money is cheap like it is now, banks can afford to either supplement cheaply or just borrow money for cheap, lend it out at higher rates and gobble up the difference. In this way you can see how the Fed is increasing the amount of money available.
When interest rates are low, then, there’s a lot of cheap money available – which goes into financing industrial activity and generally helps to get the economy firing. Just take a look at this chart.
It’s pretty clear. When interest rates rise, capacity utilization (how intensely a resource is being used) of manufacturing plants goes down. Raise rates as the Fed, and money gets cut off. Lower rates and free money tends to boost the economy.
And that’s just what the Fed have been doing since the great recession. They’ve been making money available and supporting the economy. It’s now been 7 years and the stock market has been making record high after record high. Unemployment is under 6% which is great news, and so the Fed are thinking, “jeez, maybe it’s finally time the economy learns to ride this bike on its own!”
Course, when people get used to something – the removal of said thing tends to freak them out. Hence the wild swings in the stock market as everyone tried to figure out what the Fed was going to do. People were getting nervous and it just goes to show you just how much power the Fed has – and just how much investors are reading into Janet Yellen’s every word. Yellen is the chair of the Fed, by the way, and when she speaks – markets move.
In the end, it was decided that rates would stay right where they were. Mainly due to China and inflation. The Asian giant represents America’s third-largest export partner and their growth has been falling. China’s GDP growth fell from 10% to 7%, with many economists even calling that number into question (they think it’s more like 3% or 4%).
At over $100 billion, the value of the goods America sells to China is substantial. A sizeable decrease in that number (combined with a strong dollar, which makes said goods more expensive for China already) could be like putting a sleeper hold around the neck of the U.S. economy. That’s really the last thing the Fed wants– hence rates are going to stay where they are for a while longer.
To learn more about the economy and interest rates, check this course out.
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