Is the man in the banner controlling your mind?
This post is partly about the Federal Reserve. I didn’t put that in the headline, because I at least wanted you to get to the first line of the story before falling asleep. By now, I hope you’re committed enough that you’ll read on. That’s called social engineering. And now I’m mixing a poli sci lesson with an economics one. That’s like trying to mask the taste of peas with brussels sprouts. Sorry!
So anyway, every month and a half you probably see a news headline that says something like this: “Fed: Low rates will continue.” I’m guessing that you only have a vague idea of how that’s relevant to your life. Here’s an attempt to explain it.
The announcements are as much about suggestion as they are about action.
Like a really bad boxer, the Fed telegraphs any moves it’s planning to make far in advance. That gives the market time to anticipate a change before having to feel its effects. It’s kind of the same reason pilots tell you to brace yourself for impact before the plane goes down. It softens the blow, if only a little.
That’s why investors spend as much time parsing the language of every Federal Reserve statement as they do caring about what the Fed actually did, and why even a slight word-change can send the stock market soaring or reeling. The Fed doesn’t want to come out and say what it’s going to do, but to suggest what it’s probably going to do. That way, it keeps investors from putting all their chips on one outcome, which would be disastrous for many if the Fed changed paths.
So when Fed members publicly disagree, there might be social engineering at play.
I’m not saying this is happening for sure, but I wouldn’t be the first one to say it. Most of the time, Fed members disagree in private, but keep a united front in public. In the last year or so, several Fed board members have come out and expressed their opposition to the Fed’s official decision.
This could just be a product of the unusual economic environment we’re in. But it could also be a calculated effort to keep inflation fearers happy or to strike fear in the hearts of hedge funds making huge bets about how the Fed might raise rates. Instead of a unanimous board declaring what it’s going to do, you have a divided board that seems like it could tilt the other way sometime soon.
I wouldn’t call this as much a conspiracy theory as a guess that behavioral economics is becoming much more an accepted part of macroeconomic decision making. What you make people feel is just as important as what you make people think.
That said, there’s only one way rates can go: up.
That’s not technically true. The Swedish Riksbank is actually charging a negative interest rate on bank deposits—a tactic the Bank of Japan didn’t even stoop to during its ongoing financial crisis. But so far, that’s not a path the Fed has seemed willing to go down.
Many economists expect the Fed to change its language (i.e. telegraph a rate hike) sometime during the summer and actually raise rates at the end of the year or early next year if unemployment falls. Assuming that happens, what would that mean to you?
For one, it would signal that the Fed feels we’ve pretty much clawed our way out of the recession and aren’t in great danger of falling back in. Ben Bernanke has written papers warning of the danger of cutting off economic stimulus too early. So either he and the governors are satisfied, or some political pressure has fallen on them to move rates against their good judgment.
But that signal will probably have a negligible impact on your portfolio compared to the signal that money won’t be as easy to come by in the future. At higher rates, banks have less incentive to lend money to each other, which means less money is available to borrow and invest. That can have the effect of slowing the economy down, which lowers the premium stock investors are willing to pay for a company’s growth prospects. Of course, in tandem with a Fed announcement, any number of other things can be happening. So you won’t always see a down day in the market when a rate hike happens.
And the same goes for mortgage rates. Mortgage rates are affected by the supply of money in the economy, but there are lots of things that can drive them up or down, including inflation expectations and other government stimulus programs designed to influence rates. That’s why you won’t see a great correlation between Federal Funds Rate moves and mortgage rates.
You will, however, see a pretty big correlation between the Federal Funds Rate and Treasury rates. Generally, when the Fed Funds rate drops, so do bond rates and vice versa. For you, that means a Fed move could bring down the value of your bond portfolio (bond prices move down when interest rates go up), and that’s why many investors have recommended that you tilt your portfolio to short-term bonds that won’t be as heavily impacted.
Anyway, while the Fed didn’t change its rates or its language this time, I hope this helps you digest why your portfolio does what it does when the Fed makes a change.