In his speech on Wednesday, Fed Chairman Jerome Powell vowed to keep interest rates low for several years while the economy continues to recover from COVID-19 shutdowns and the ensuing recession. Why does this matter? What are the economic benefits of low interest rates? What are some of the downsides? In this blog post, we look at why the Fed decision matters and how it may impact your portfolio.
The Federal Reserve is not only the central banking system for the United States, they also set certain monetary policies in our country. The Fed has a “dual mandate” in which they look to achieve full employment while keeping inflation in check. To carry out this mandate, the Fed will often adjust their target “Federal Funds” rate (i.e. the rate banks charge other banks for overnight loans to each other).
Why does this matter? The short answer is lowering this rate will lower the interest rate that banks will have to pay to each other for these overnight loans. This often trickles down to individual borrowers as well. When the Fed lowers the Fed Funds rate, banks can borrow cheaper and thus can lower the interest rate they charge their customers while still maintaining their profit levels. Cheaper borrowing entices consumers to spend more money, thus propelling the economy out of recession (the opposite would be true if the Fed were raising the Fed Funds rate). There is obviously more that goes into this equation, however this is one fundamental reason why the Fed can help change the trajectory of the economy simply by raising or lowering its benchmark interest rate.
The mysteries of the U.S. economy are now solved, right? As Newton’s third law states, “for every action, there is an equal and opposite reaction”. The U.S. economy is no different. There are always unintended consequences that accompany lowering interest rates as well as keeping them low for extended periods. Ultra-low interest rates can, and have, negatively impacted savers and retirees. The chart below, from the Federal Reserve Bank of St. Louis, shows the interest rate on a 10-year U.S. Treasury bond from 1962 until the present.
As you probably noticed, treasury bond yields are at all-time lows. Back in 1980, a retiree could invest $100,000 in a 10-year treasury bond and receive an interest rate of about 12.5% over this 10-year horizon. This means that a retiree, back in 1980, would receive $12,500 in annual interest from that bond. Today, this same retiree would only receive $690 (0.69%) in annual interest from this same 10-year treasury bond! How can anyone live off this, especially with the rising cost of living over time? Naturally, this is a major concern facing investors today and an unintended consequence of extremely low interest rates.
In his speech on Wednesday, Jerome Powell also vowed the Federal Reserve would hold interest rates near zero for at least three more years. This means that investors looking for more income in their portfolios could continue to face a challenging investment environment for years to come. While the Fed may control the Fed Funds rate, there is a multitude of other factors that affect interest rates (e.g. supply and demand for money). If you are an investor looking for ways to generate more income in your portfolio, please contact us today!