Cutting Interest Rates

By Kevin Chambers

The Federal Reserve lowered interest rates on the afternoon of July 31^st. This was the first cut from the Federal Reserve since just after the recession of 2008. They set a new target rate of between 2.00% and 2.25% for the Fed Funds Rate, the rate that other banks borrow from the Fed and helps set interest rates across the curve. To better understand how this action affects your investments, let’s revisit the role of the Federal Reserve and how they change interest rates.

The Federal Reserve, the central bank of the United States, is supposed to be a politically neutral institution that helps to control the money supply of the US economy. Changes in the money supply affect economic growth and inflation. At the most basic level, this is what the Federal Reserve is trying to balance. Having too much money circulating in the economy causes inflation; not enough money in the marketplace will hurt economic growth.

So why do interest rates matter? Think of interest rates as the expense of borrowing. High-interest rates mean borrowing money is expensive. Low-interest rates mean borrowing is cheap. Cheap borrowing encourages businesses and individuals to borrow, and thus spend more. This, in turn, helps spurs economic growth. If the Federal Reserve is worried that the economy is faltering, they will lower interest rates to try and get more money flowing through the economy through increased borrowing.

For the last decade since the economic crisis, the American economy has been doing well. The Fed kept interest rates low for most of the decade but was confident enough in its strength to start raising interest rates. They were more concerned with our economy getting over-heated than falling back into a recession. There are some other advantages of getting interest rates back to a higher level. The number one advantage is that it allows the Fed the option to lower rates again. The Fed Funds rate (the primary interest rate that the Fed manipulates) was over 5% pre-2008. One of the reasons their actions were so successful in restarting the economy after such a disastrous stock market crash was that they took rates to zero almost right away. The ability to lower interest rates is an indispensable tool for the Fed to have in their toolbox. A second significant advantage to increasing interest rates is that higher interest rates encourage saving overspending. At Headwater Investments, we work with clients saving for retirement. With low interest rates, savers get the short end of the stick. It especially hurts savers that rely on their savings to live, like many retirees.

It will be interesting to see what the Federal Reserve does going forward. The new Fed Chair, Jerome Powell, indicated that the Federal Reserve does not have a formal plan going forward. They are going to make decisions on a quarter-by-quarter basis, a divergence from prior chairs, who liked to layout a multi-quarter, or even multi-year plan. So this could have been more an ‘insurance cut,’ a one time action to offset some of the global uncertainty. The uncertainty Powell mentioned concerned growth slowdowns in China and Europe and current US trade policy. The Fed expects the US Economy to remain strong and the labor market to continue its robust run. However, the unknowns in the market caused them to pause.

Financial markets and investors prefer certainty to uncertainty. Or as close as they can get. Because the Fed has decided to take their decision making on a more pragmatic schedule instead of a set plan, there is more uncertainty being introduced. The stock market fell as the announcement came across desks late in the day on the 31^st. We will be monitoring this situation closely.