Understanding the Feds interest rate agenda
The U.S. Federal Reserve is the world’s most powerful and influential central bank. As part of its mandate, the Fed serves as the decision-making body for U.S. monetary policy. Through management of short-term interest rates and the availability and cost of credit, it seeks to manipulate spending, investment, employment and inflation to foster economic growth.
The Fed’s main tool in this endeavor is to adjust the benchmark fed funds rate, upon which short-term debt is often based. In response to the economic fallout of the COVID-19 pandemic, in early March, the Fed slashed the fed funds rate from a range between 1.50-1.75% to near 0%. By effectively lowering interest rates on short-term debt such as credit cards, short-term bank loans, variable rate mortgages and home equity lines of credit, the Fed hopes to induce consumer and business spending to boost economic growth.
The Fed has eight scheduled meetings each year where it reviews its interest rate agenda. On Wednesday, the minutes for its April 28-29 meeting were released. The significance of the minutes is that they provide insight into the Fed’s internal discussions on the state of the U.S. economy and its monetary policy.
Within the minutes, the Fed acknowledges the worst of the COVID-19 virus appears behind us and that states have increasingly begun to reopen their economies. The Fed expects economic growth to “rise appreciably and the unemployment rate to decline considerably in the second half of the year, although a complete recovery was not expected by year-end”. However, the Fed notes that tremendous risks and uncertainties remain, citing the recent deterioration in economic growth, the labor market and foreign trade.
Looking ahead, the Fed indicates no further adjustments to interest rates until it has confidence the economy and labor market are on a sustained path to full recovery. Moreover, the financial markets currently project less than a 1% probability the Fed will enact any rate changes through a least March 2021.
Over the past few months, there’s been growing chatter the Fed may resort to “negative” interest rates. Though never before used in the U.S., many nations around the world have dabbled with negative interest rates, most notably in Europe and Japan. For example, the current yield, or return, on the U.S. 2-year Treasury note is 0.16%. Granted, a 0.16% return is low. But for investors seeking safety and security, U.S. Treasuries are backed by the full faith and credit of the U.S. government.
Now, compare this to the -0.552% yield on the French 2-year note or the -0.689% yield on the German 2-year note. As the name implies, with negative interest rates, you are actually paying the government to loan them your money. If an investor were to purchase $1 million of French 2-year notes, upon maturity in two years, the French government would pay back the investor only $994,480. This begs the question – why would investors willingly accept a guaranteed loss on their investment?
During times of extreme uncertainty, investors often seek shelter in low-risk investments. And some of the safest investments are government-backed bonds, notes and bills. For many, placing their money in a government-backed instrument – even if it offers a negative interest rate – is preferred over the potential risk of substantial losses in the stock market.
For nations offering negative interest rates, the benefit is obvious – they lock in a guaranteed profit on all investor money they receive. But the true agenda is motivated less by profit and more by economic necessity. When a nation’s central bank – including the U.S. Federal Reserve – lowers interest rates, it inherently acts as a disincentive to saving. When interest rates become negative, investors are actually punished for saving their money. The central bank’s goal is to implicitly force savers and investors to spend their money on goods and services which helps stimulate economic growth.
But negative interest rates come with sizable risks. Primarily, investor money tends to flee the country in search of higher, and positive, yields. In today’s world of global markets, this often comes with the click of a button. Consequently, negative interest rates often drive money out of the country rather than being used to boost economic growth.
Here in the U.S., Federal Reserve Chair Jerome Powell has publicly dispelled any notion the Fed would resort to this tactic of monetary policy. Absent any fall/winter resurgence in the COVID-19 virus, Americans should expect a continuation of very low interest rates through the rest of the year. Just don’t expect to see negative rates.
Mark M. Grywacheski, Investment Advisor
Opinions expressed herein are subject to change without notice. Any prices or quotations contained herein are indicative only and do not constitute an offer to buy or sell any securities at any given price. Information has been obtained from sources considered reliable, but we do not guarantee that the material presented is accurate or that it provides a complete description of the securities, markets, or developments mentioned.
Quad Cities Investment Group, LLC is a registered investment advisor with the U.S. Securities Exchange Commission.
