A FEDucating Article on the FED’s Limits and Rallying Stocks Despite Rising Interest Rates
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.
Do Negative Interest Rates Work?
by Andrea Lan
Countries such as Japan, Switzerland, and Denmark are dabbling in the world of negative interest rates in an effort to encourage spending. Negative interest rates are exactly what they sound like: instead of earning interest on savings, the central bank will shrink the account balance on bank reserves. Theoretically, central banks will target a negative overnight lending rate in an effort to encourage people to spend and banks to loan in order to increase demand for borrowing, while lowering the cost of borrowing.
This however does not mean that all interest rates are negative, it is just a rate that the central bank targets.Fundamentally, people need incentive to save. Thus, the longer people lock down their money, the higher the interest rate will be on those savings. Shown in the chart on the left, the short term lending rate starts negative, while long term bonds still yield a positive return. Consequently, banks are struggling to make a profit and keep excess reserves for overnight interbank lending.
Nevertheless, the theory behind negative interest rates remains to be just that: a theory. Reality shows that negative interest rates do more harm than good. In response to near negligible inflation and falling prices, Japan introduced a .1 of one percent fee on banks’ reserves in 2014. Two years later, “core consumer prices [still] fell .5 percent”. Additionally, only two months post negative interest rates, demand for Japanese bonds increased. Suggesting that despite negative interest rates, people were still willing to secure their money in bonds rather than spend it. Four years later and Japan has yet to hit its 2% target inflation. Though Japan has recently seen a small boost in their economy, it would be a reach to credit it to negative interest rates given the recent increase in prosperity within the global economy. Undoubtedly, the recent inflationary pressures could very well explain the boost in price levels that many of these countries have been looking for. While this unorthodox form of monetary policy has put more money in circulation, it does not mean that the money is being well spent or, for that matter, even spent at all.
The long term effectiveness of negative interest rates is questionable. Although low interest rates make borrowing cheaper, it does not mean the investments being made are in the interest of increasing capital stock, labor force, and furthering education. Looking into a country who is no stranger to negative interest rates, Denmark has been below zero for five years this July while their prosperity remains dubious. Despite Denmark’s flourishing housing market, the high-risk borrowing that comes with low interest rates leads to unreliable loans. Leaving the country with an influx of potentially-questionable loans if the interest rates were to ever rise again. If the interest rate were to resume positive rates, many will no longer be able to afford their loans, posing the threat of defaulting on loans… sound familiar? In 2008, the millions of people who defaulted on loans which they could not afford largely contributed to the catastrophic collapse of the housing market.
All in all, this new phenomenon has not been proven to be effective in the short run and poses many potential problems for long term growth of an economy. Putting more money in people’s pockets does not guarantee that they will spend it.
Intrigued? This will not be the last that you hear of the fascinating world of negative interest rates, Although interest rates are negative our interest in them certainly is not!