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Fed Rate Reduction - Tell Me Again Who That Helps?

Fed Rate Reduction - Tell Me Again Who That Helps?

August 07, 2019

On the last day of July, 2019, the Federal Reserve lowered the fed funds rate for the first time in over ten-years. The rate increase was widely expected for several weeks prior to the change, but I admit I’ve struggled with the rationale behind it. The economic justification for Federal Reserve monetary policy has always seemed sound – help the economy through economic cycles with actions affecting our country’s money supply, and therefore, improve our ability to expand (jobs, investments, research, factories, etc.) and contract when necessary. This is what I was taught throughout my educational and professional learning. I’ve also witnessed the application of this policy for almost four decades now. But here’s the thing: the primary factor the Fed has virtually used to measure the strength or weakness of the economy and therefore, justify their actions, has been the unemployment rate – JOBS! We have the lowest unemployment rate in over 50 years, so the economic theory of lowering rates to stimulate jobs doesn’t seem to fit this particular rate cut. Is the recent rate cut going to help our historic employment numbers get even better?


An Economic Stimulant (or just lower borrowing costs for investors)?

Traditionally, when the economy was struggling and unemployment was high, lowering interest rates through Fed monetary policy would “stimulate” the economy, prompting companies to hire more workers and vice versa. When the economy is growing, the Fed has traditionally been concerned that lower unemployment could translate into higher prices and dreaded inflation would rear its ugly head. Raising rates is seen as a measure to “cool off” the economy (see wage/price spiral chart). However, surveying the economic landscape today would hardly suggest we were anywhere near the need for Fed intervention. So why the rate cut?

Unemployment has traditionally been the driver of what the Fed does with its fed funds rate. The Fed funds rate is what banks borrow from each other – it doesn’t necessarily mean interest rates will go up in general everywhere, but it does affect the cost of the initial borrowing source by large banks and financial institutions – they in turn raise their rates down to their borrowers, and down the line it goes.

The theory works something like this:  When the economy is booming (definition becoming more open to interpretation), one of the concerns of the Fed include a higher demand for workers, and therefore their wages will rise and create a wage/price spiral (see diagram).

The problem with the wage/price spiral theory is that there is little, if any, evidence to suggest that there has ever been a strong correlation between higher employment and inflation. In other words, more people getting jobs doesn't translate into higher general prices. Since 2009, employment has increased to and the annualized inflation rate has increased only. I believe wages are not as sensitive to labor demand as they were in the past because of globalization, reduction of collective bargaining agreements, lower employer paid benefits, and stagnant "real" wages (adjusted for inflation) for close to forty-years.


Who Benefits From Falling Rates?

Borrowers – To the extent the rate reductions extend to debt payments for mortgages, refinancings, student loans, and adjustable loans, there could be a positive cash flow impact to borrowers. Traditionally, lower rates could create a greater demand for housing. However, any problem with the current housing market is not necessarily because of cash flow affordability (at least that a ¼%  rate reduction can provide), but rather the demand for housing across the country exceeds the supply – we’re not building them fast enough.

But Not Credit Card Holders - If credit  If you have an unsecured credit card, the average national rate is 17.80% , which is an all-time high¹. Large banks and financial institutions benefit from borrowing funds at decreasing rates while at the same time borrowing rates for the average unsecured credit card is surging.

¹According to

Who Doesn’t Benefit From Falling Rates?

From a global economic view, any lender who is depending on adjustable interest income will probably have their incomes drop. But the more direct impact that falling rates have is on individuals who earn interest from their savings accounts (and CD's). From the perspective of a retiree, what essentially happens with a Fed rate reduction is the inevitable decrease in savings rates. These investments are typically federally guaranteed or privately insured. The lower savings rates will not keep up with “real” inflation (see next month's blog on the ridiculous low Consumer Price Index (CPI) measurements).

Retirees who want better returns than the low-risk investments available, are being compelled to seek higher returns in the capital markets – stocks and bonds. This creates a level of risk that most retirees probably thought they wouldn’t be dealing with at this stage of their financial lives. Below is a chart demonstrating that even minor changes in savings rates over the long-term can be significant for many retirees. 

We believe Financial Planning includes the identification of all relevant investment opportunities and the ability to determine if they are a right fit for each client. The direction of future interest rate changes remains uncertain but constructing portfolios that are globally diversified can help reduce risk without sacrificing returns. If rates remain low, it may make sense for you to seek advice on how your portfolio returns can keep pace with inflation,  how your returns are aligned with your risk tolerance, and how you can have access to a more efficient way to invest. Please feel free to contact us to schedule a no-charge consultation or if you simply have questions. Please review our website for additional educational and helpful resources.