Monday 30th of September 2024
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Many people think the Federal Reserve (the Fed) plays a huge role in controlling the economy by setting interest rates. But some experts argue that the Fed’s power might be more of an illusion. Let’s break down what this means and why it’s a big deal for everyone, not just those who follow finance.
The Fed is like the US government’s bank. One of its main jobs is to set a short-term interest rate called the “federal funds rate.” This is the interest rate banks charge each other for short-term loans. The Fed changes this rate to influence other interest rates in the economy, like those for mortgages, car loans, and credit cards. The idea is that by raising or lowering this rate, the Fed can help control things like inflation or stimulate the economy during tough times.
Recently, there’s been a debate about whether the Fed’s actions are really effective or if it’s just been lucky in controlling inflation through raised interest rates.
Some economists argue that while the Fed sets one rate, it doesn’t actually have much control over the important rates that affect everyday people. For instance, when the Fed raises its rate, you might expect mortgage rates to rise too, but that doesn’t always happen. Sometimes they move in opposite directions, or not at all.
New York University professor Aswath Damodaran is one of the experts who believes that the Fed’s power might be overrated. He argues that the Fed’s rate is just one of many factors that influence interest rates on things like mortgages and business loans. Sometimes, these real-world rates don’t change in line with the Fed’s rate changes at all. For example, between 2004 and 2006, the Fed raised its rate by more than 4%, but other rates, like those for certain corporate bonds, barely moved. This suggests that markets often ignore what the Fed does.
Damodaran and others say that real-world interest rates, like those on your mortgage or credit card, are mainly driven by two factors: how the economy is growing and expectations about inflation. Neither of these is controlled by the Fed. For example, interest rates were low before the pandemic not because the Fed kept them low, but because the economy was weak and inflation wasn’t a concern.
On Wall Street, the consensus idea is that the Fed is in control and its rate decisions affect the economy. If the Fed doesn’t have the power people think it does, then a lot of what investors and analysts focus on might be wrong. It would be like following rituals for a god that doesn’t exist.
This view has support. Financial Times writer Martin Sandbu has argued that the recent spikes in inflation were mostly due to supply chain issues and other disruptions, not because of anything the Fed did or didn’t do. If that’s true, then the Fed’s efforts to control inflation might not have had much effect.
Some say the Fed’s actions might matter during major crises, but even then, their impact is limited. For instance, in 2007, the Fed tried to prevent a recession by cutting rates, which initially boosted stock prices. But as the economy continued to weaken, those rate cuts weren’t enough to stop a downturn.
The Wall Street Journal’s Spencer Jakab recently compared the Fed’s chairman, Jay Powell, to the Wizard of Oz, powerful in appearance but not as effective as people think. He noted that during past crises, what really drove markets wasn’t the Fed’s rate cuts but broader economic trends, like whether the economy was growing or shrinking.
If the Fed is more of a follower than a leader, what should you do as an investor?
For one, you might not need to worry so much about the Fed making mistakes, like raising rates too high and causing a recession. Instead, paying attention to the overall health of the economy and how companies are performing might be a better strategy.
In 2022, many investors were nervous about the Fed’s actions and avoided risks, only to miss out on the gains of 2023. If they had focused on the economy itself rather than the Fed, they might have made different, and potentially better, decisions.
In the end, it’s important to remember that while the Fed plays a role, it’s not the all-powerful force many believe it to be. Understanding the bigger picture can help everyone make smarter financial choices.
We would like to thank Dominion Capital Strategies for writing this content and sharing it with us.
Sources: Bloomberg, Yahoo Finance, Marketwatch, MSCI.
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