In an effort to stimulate the economy, we have witnessed the Federal Reserve aggressively reduce interest rates over the past year. The latest rate cut on April 30 lowered the Federal Funds rate to 2.00%, which made for the seventh cut in seven months. However, when the Fed met last week they decided to keep interest rates at this level because the risks to downside economic growth have diminished. So why exactly has the Fed chosen to reduce rates? Has it worked? And how have these rate cuts affected you?
The Federal Reserve acts as the central bank of the United States and its purpose is to create monetary policy. By influencing money and credit conditions in the economy, it works to achieve the nation’s macroeconomic goals. These goals include stable prices, high employment, and maximum stable growth. One tool that the Fed uses to create monetary policy is the federal funds rate, which is the interest rate that banks charge one another for very short-term loans. Since the fed funds rate dictates interest rates for when banks borrow, it also influences the rates at which they lend. This, in turn, affects other short-term interest rates in the economy, economic activity, and the rate of inflation.
Due to the fact that ever-changing market and political conditions, both domestic and international, also play a major role in the economic and financial decisions of businesses and households, it is difficult to pinpoint the direct results of monetary policy actions. However, the Fed’s influence over short-term rates can create conditions conducive to economic growth.
Traditionally, lower interest rates tend to stimulate the economy. For businesses, lower rates make it easier to borrow in order to invest in equipment, inventories, and buildings. These investments make the economy grow at a faster rate as productivity, measured in output per worker, increases faster. On an individual level, reduced rates make it easier for people to borrow in order to buy cars and homes. Such purchases cause additional demand for furniture, appliances, and other consumer products. At the same time, the decrease in interest costs leaves consumers with more of their income to spend on goods and services.
While it is true that there have been many benefits from these changes, individuals have seen their CD and money market yields decline dramatically since the interest rate cuts began. As of June 30, the national average for a one-year CD is 3.28%, and 3.88% going out five years. Given an inflation level of roughly 4% and accompanying illiquidity restraints, these investments have little appeal for most people. For this reason, I believe that low money market fund yields will force individuals to start getting back into the market. Rather than earning next to nothing in a money market, I suggest investing in companies with high current dividend yields and downside protection. A few names to look at include General Electric (current yield of 4.7%) and AT&T (4.9%).
It has been widely speculated that we may not see any rate changes until December. Says William Poole, who retired in March as president of the St. Louis Federal Reserve Bank after a decade on the Fed’s rate-setting committee, “The Fed will want to be as low-key and invisible as possible and that means the Fed will not want to change the funds rate ahead of the election.” Nonetheless, Mr. Poole then added that the Fed will act before the November 4 presidential election if given a “compelling case.”
Filed under: Economy
