Tuesday, September 22, 2015

What Do Interest Rates Mean, Anyway?


     I don't know if you even noticed, but a few days ago the entire financial world was on tenterhooks, wondering whether or not Janet Yellen and the Federal Reserve would dare (gasp!) to raise interest rates by ... get this, a whole 1/4 of a point.

     Frankly, I don't know what the big deal is. I remember interest rates at 12 and 15 percent in the early 1980s. So a quarter point, to me, seems negligible. Besides, I don't really care if I get the current 0.1 percent interest on my CD, or whether I get 0.35 percent interest. Either way, all I'll be able to buy with my interest is a pack of gum, or 1/4 of a gallon of gasoline.

     So I turned to my friend Jeremy Kisner, Senior Wealth Adviser at Surevest Wealth Management in Phoenix, to do some explaining for us. Here's what he says:

Jeremy Kisner
     Whether you prefer higher interest rates or lower rates depends on whether you are a saver or a borrower. The last time the Federal Reserve raised interest rates was June 2006. The Fed started cutting rates when the economy began deteriorating in late 2007, and it eventually cut rates to zero in December 2008. We are likely to see the first increase since the Great Recession by the end of this year

      Raising the Federal Funds rate is controversial. This is the only interest rate that the Fed directly controls. It is the rate that banks charge each other for overnight loans, and it primarily affects money market and savings accounts. The rate for mortgages is largely determined by the supply and demand for bonds, which the Fed does not directly control. A large group of economists think it is a terrible idea to raise the Fed Funds rate at this time. Others feel it is long overdue.

     Let’s try to understand why.

     The U.S. government has two ways to try to stimulate the economy: Fiscal Policy (government spending) and Monetary Policy (interest rates and money supply). The Federal Reserve is only responsible for monetary policy. The Fed’s two overarching goals are:

     1) Promote maximum employment, and

     2) Keep inflation as close to 2% as possible.

     Maximum employment and low inflation tend to be conflicting goals, which makes the Fed’s job a balancing act. Maximum employment (i.e., low unemployment) is usually only achieved when there is strong demand in the economy. Strong demand for products and services is good for employment but bad for inflation (pushes prices up). The Fed lowers interest rates when the economy is slow in order to stimulate the economy. On the other hand, it will raise interest rates if the economy is overheating and inflation is above its 2% target. You can see how it is difficult for the Fed to please everyone.

     Many people complain that it doesn’t even pay to keep your money in the bank at today’s interest rates. That was the Fed’s whole idea. It was trying to get you to take your savings out of the bank and go invest it in things that create jobs (e.g., new property, a factory, or equipment). The low interest rates of the past seven years have been good for young people who tend to be borrowers and job creators. The low rates tend to penalize seniors who are counting on interest from their savings accounts to supplement their retirement incomes.

     Zero interest rates have helped the U.S. economy recover from the great recession. The recovery has not been as quick or as robust as many would have liked. However, there's no question that the economy is bigger and stronger on almost every measure than it was before the 2008-09 recession.

     The question is why raise rates now? The economy is not in danger of overheating, and inflation is below the 2% target (largely due to the decline in energy costs). There are several reasons but the main ones are:

     1)  0% is an extreme measure, and the Fed likes to have some ammunition in case of a future downturn or economic shock. When rates are already at zero, it has very few tools left.

     2)  Historically, low rates can create asset bubbles. In other words, people start investing in things that don’t make sense. (Has anyone checked real estate prices in Silicon Valley or New York City?)

     How will a rate increase affect the economy and the stock market? Short-term, there is some volatility, but in the medium to longer term, an increase from 0 to .25% should be a non-issue. The Fed just wants to get off of zero. It is unlikely there will be any steep increases from there unless inflation makes a significant comeback.

8 comments:

DJan said...

Thanks for the information, Tom. I figured that Wall Street's volatility over possible minuscule amounts is trying to keep them from going up at all, like bullies threatening to take their marbles home if you don't do it their way. :-)

Anonymous said...

I don't now where you bank but I am getting 2% on my CD's and 3% from Vanguard. All FDIC. Considering that I had a measly $10K as an experiment invested in the S&P 500, it had made $800 in profit plus 4 dividend payments over the year (approx $55 each). Today, all of that profit is gone, plus the dividends and some of my capital. In other words, a big loss as far as I am concerned.
Meanwhile, my little CD's keep chugging along, making me a little money and never, ever losing a dime.
As an ancient CPA once told me: better to make a little money than no money at all.
As soon as my ETF returns back to my original investment, it's outta there. To heck with paper profits and preposterous evaporating dividends.
PS: all my investments are ROTH IRA's (over the years) so no taxes are due.
Want to make money in retirement: get a part time job, sell something and/or keep lowering your expenses, keep yourself healthy and eat more vegan meals.

Olga Hebert said...

I learned something new--really did not realize the purpose of low interest rates. I cynically thought it was a plot to get rid of the middle class.

billy pilgrim said...

i think currency wars play a large part in setting interest rates.

Stephen Hayes said...

I enjoyed this clear explanation of the federal interest rate. I don't invest in the market and would prefer a decent interest rate, but that doesn't seem to be on the horizon.

Kathy @ SMART Living 365.com said...

Hi Tom! I'm not sure I agree with everything that your friend and advisor said. Unfortunately while I know that the government is keeping rates low to "stimulate" the economy, that seems to mostly be benefiting the banks because they get to "borrow" it and then turn around and lend it out and make a lovely spread for themselves. Meanwhile they have been stimulating real estate prices (which surely would not be as high as they are now if people didn't get extremely low rates to buy) and that is artificially raising prices. Here on the west coast prices are almost back to the crazy amount they were before the crash and instead of putting money into business and stimulating the economy, people with money are investing in real estate to "hold" the investment. Besides, didn't Japan try the -0- interest thing for a while and then have it blow up in their face? I think I agree with Olga above....

Gabbygeezer said...

Kisner's explanation and the formula for a sensible retirement financial strategy given by Anonymous are both spot on.

Tom Sightings said...

I'd agree with Anon., too, except I don't know where he/she get the figures. At my major national bank, you do not get 2% on a CD. You get 0.35% for a three year CD, and 1% if you're willing to tie up your money in a ten-year CD. (Will I be dead by then?) As for Vanguard, you can only get 3% if you invest in a long-term bond fund, or a dividend stock fund -- both of which expose you to potential loss of capital. So, for me anyway, the conundrum of where to get some decent, safe income from our retirement savings remains unsolved. Until that changes, it's bread and water in our household!