By: Andrea Lan
There is a common misconception that the FED is this high and mighty government power designed to fix any problem that comes our way; however, there is only so much the agency can do. The FED was designed to stabilize conditions as much as reasonably possible in order to keep our country on track for long-term growth.
There are limits though, to its control over current economic conditions. The Fed uses three main tools to help, or ease, the economic environment: Open Market Operations, the Fed Funds Rate, and the Reserve Requirement. These tools allow the FED to affect interest rates and bank balance sheets. Although these tools allow the FED to cause certain effects in the economy, history has proven that it is difficult for the FED to control what actually happens after interest rates or bank balance sheets are changed. After the financial crisis in 2008, the FED kept interest rates zero bound in an effort to encourage spending to foster economic growth. Despite almost a decade of near zero interest rates, spending rose minimally and people continued to borrow, demonstrating the Fed’s limited power over economic conditions. Its policies often do not allow them to fix problems such as “large scale investments, infrastructure, job training, and education” which will promote stable economic growth. The FED does not have the power to increase funding in education or pass legislation regarding these issues. Only Congress and the President hold those powers. The market today is another prime example of the limited powers of the FED to definitively control the economy. Even with recent hikes in the interest rate that hypothetically should decrease the value of stocks, stocks do not seem to be taking a hit.
Generally, when the Fed targets higher interest rates*, it causes a ripple effect. With a higher Fed funds rate, it is more expensive for banks to borrow money, which in turn makes it more expensive for individuals to borrow from banks. The same thing goes to say with companies. Higher interest rates discourage companies to invest in large projects to expand or increase productivity, thus slowing company growth. As the cost of capital goes up, capital intensive companies may feel a direct impact on profits. Consequently, public companies’ stocks decrease. Such a scenario though, is clearly veering from the expected.
Bringing us to today’s question: So if interest rates are rising, why are stocks still rallying?
Fundamentally, if businesses are able to make up for the increase in cost of capital, their stocks can continue to grow. For example, if companies are able to find a cheaper way to produce their goods, they can widen profit margins. In addition, the FED usually targets a higher interest rate to combat rising inflation. Thus, the “rallying” stocks may just be a result of high inflation, creating a false sense of economic prosperity that will ultimately be short lived. Another potential reason for the rising interest rates correlating with a strong stock market is the current administration’s campaign promises. Discussions about more oil drilling and infrastructure building have helped the energy sector and the material sector prosper. At the same time, possible tax cuts and deregulation have raised expectations of future growth in the stock market. It is also possible that the increase has nothing to do with the President’s discourse, since stocks have been thriving since early 2016. Further proving that despite popular belief the FED’s power to “control” the economy is very limited.
*To be clear, the FED does not directly raise or lower interest rates, they adjust the interest rate by raising or lowering the Fed Funds Rate.