Why is the Fed raising interest rates, and what is ZIRP?
In late July, the Federal Reserve increased interest rates by .75 after a previous increase of the same magnitude the month prior. The target rate is now at 2.25% off the rock bottom levels we have seen for the past few years.
“Interest rates” can mean a lot of different things.
Typically, “interest rates” is the term for the short-term federal funds rate. Many of the other longer-term rates such as the 2,10 or 30-year treasury have their own behaviors but react off this short-term fed funds rate. Mortgage rates often take their cue from the 30-year treasury rate, so it has a cascading effect.
What’s the federal funds rate?
The Fed Funds rate is the interest rate set by the Federal Open Market Committee or FOMC. This is a group of individuals that meet throughout the year to read the economic tea leaves and set the interest rate policy based upon that. This week, “The Fed” bumped up rates again by .75% to a current rate of 2.25%. Banks have regulations determining their “reserves” or how much cash per dollar of deposits they have. When money is sloshing in and out of the bank by deposits, withdrawals, loans being lent out and paid off, these reserves can be off balance. This creates the need for banks to lend to and from each other at the “target federal funds rate”.
I have a fixed-rate mortgage; how does this rate affect me?
Having a fixed mortgage in place does provide tremendous peace of mind. Many have heard the horror stories of the variable rates back in 2007 when many mortgages reset to higher rates and caused folks to miss mortgage payments. Homeowners with a fixed rate mortgage in a home they want to stay in for the long haul are in a great place right now. This trend during the recent cycle is why we are unlikely to see a repeat of the housing crisis of 2008.
Two sides of the same interest-rate coin
Adjusting the interest rate environment is always good for one side and bad for the other, those sides being the saver and the debtor. For many retirees (savers) they have had a difficult time generating income safely from government bonds or other fixed instruments as they have been punished earning close to zero on their life savings.
On the other hand, low rates have provided an “easy” environment for debtors as they could get zero percent interest car loans, 3% mortgages, and other favorable rates comparing to years past. This enables and encourages economic activity as people are stimulated into buying homes, cars and other spending as their debt payments are now much lower.
Increasing rates is now having the reverse effect. Allowing interest on savings to be bumped up a bit but debt is now more expensive for Americans which can put a drag on the economy. By increasing interest rates, putting a drag on the economy is exactly what the Federal Reserve is trying to do without crashing us into a deep recession. Slowing the economy down brings inflation down because there is now less dollars chasing the goods and services.
Interest rates impacting the stock market
The short-term interest rates typically don’t just affect the rate on a loan or a savings account but are a major determining factor in how the stock market behaves. Suppose for example, someone has $100,000 to invest and they don’t have plans to use the money for 10 years. Let’s assume the interest rate on their FDIC insured bank account is offering to pay them 6% interest per year for their deposit. If they then look at a potential stock investment that is paying a dividend of 3% per year, they have some mental math to consider. They could get 6% at the bank with zero risk or they could get 3% from the stock investment but has potential to make much more and the risk of losing some or all of it. For many investors, the bank savings at 6% risk-free seems like a great deal.
Let’s now look at a zero-interest rate policy or “ZIRP” where your bank offers you nothing for your savings like we have seen for the past 5 plus years. Investors are suddenly more tempted to put cash into riskier investments like stocks because they are appalled at getting a zero percent return. ZIRP, typically also means very low rates on other safe investments like treasuries, municipal bonds or corporate bonds. Investors are now looking at blue-chip stock investments that pay 3% dividends with upside potential. We can see how the Fed may be responsible for creating asset bubbles.
ZIRP created TINA
Wall Street loves acronyms. There is no alternative or “TINA” has been one of those coined during the Covid recovery implying the stock market was really the only game in town for investors wanting some type of return.
Most investors were considering their alternatives and hard to blame them for looking to the stock market as a solution to their investment returns problem:
• Cash savings and checking paying zero
• 2-year treasury bonds paying .15%
• 10-year corporate bonds paying .53%
• 30-year treasury bonds paying 1.13%
• CD’s paying close to zero
• Stock market which seemed to be going up every day during 2020 COVID recovery creating a “fear of missing out” phase.
A prime example of this were the unprofitable technology stocks coming out of the COVID-19 environment where the Federal reserve kept rates at zero. Many start-up technology stocks pay no dividends, lose money every quarter, but have the promise of growth and profits many years from now. A ZIRP makes this type of investment more palatable, as many investors were more willing to be patient for the future profits given the opportunity cost was so low.
As the Fed has begun increasing interest rates the less profitable companies have had reality hit them hard. Cryptocurrencies are another speculative investment with no underlying business cash flows behind it that has followed a similar trend.
Asset prices going up and down with Fed policy
The lower rates are, the more cash tends to find places other than bank savings accounts such as stocks, cryptocurrency, real estate, art, NFT’s, you get the idea. The higher rates go, the more cash tends to make its way back into savings accounts, CD’s, and bonds. When there is less cash circulating around in the investment world and sitting idle in banks, the lower the stock market and other asset classes tend to go. When the stock market goes down, the “wealth effect” gets reduced and people tend to take less vacations and spend less. This cools off the economy and brings inflation down.
Keeping it simple with interest rates
Rising interest rates incentivizes more savings and discourages investment and spending. Interest rates going down incentivize borrowers to take out loans and buy things, and investors to invest.
The Fed now has their hands full with inflation at its highest point in over 30 years. They face the difficult task of raising interest rates enough to cool the economy without triggering major damage by slamming the breaks too hard.
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