The Fed: Facets and Functions

The Federal Reserve (or The Fed) has a big impact on the economics of the US and it’s banking system. So how does this effect every day investors? Jose Torres, Interactive Brokers’ Senior Economist, joins Cassidy Clement, Senior Manager of SEO and Content to discuss.

Summary – Cents of Security Podcasts Ep. 27

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement 

Welcome back to Cents of Security podcast. I’m Cassidy Clement, Senior Manager of SEO and Content at Interactive Brokers. Today I’m your host for our podcast, and our guest is Jose Torres, Interactive Brokers’ Senior economist. We’re going to discuss the Fed. The Federal Reserve or The Fed has a big impact on the economics of the US and its banking system. So how exactly does this impact everyday investors? Well, we’re going to find out. So welcome back to the program, Jose. 

Jose Torres 

Hi Cassidy, great to be here. Thanks for having me again. 

Cassidy Clement 

Sure. So to kick off for our listeners, what exactly is the Fed? What are their common functions? 

Jose Torres 

Sure. So the Fed is the central bank of the United States. Part of their functions are to print bills, set monetary policy, and set short term interest rates. And their two primary mandates are to maximize employment and achieve price stability, which they define as the core PCE (personal consumption expenditures) price index rising 2% year over year. They also do some bank regulation as well. 

Cassidy Clement 

So, they are the ones who conduct the monetary policy for our country or for the United States, correct? 

Jose Torres 

Yes. 

Cassidy Clement 

And then with the big events that everyone talks about, usually like the Fed meetings, how many times a year are they meeting and do we know ahead of time when these are going to be and how quickly they’re going to happen? 

Jose Torres 

Yes, absolutely. They meet 8x a year for an interest rate decision. Those dates are known well in advance. For example, today we have all the dates for 2024. 4x a year they released the summary of economic projections. This is also called the SEP or the dot plot. And that provides market participants with forecasts of where the Fed sees several different indicators. So economic growth is one. Unemployment is another. Inflation is another. And of course, the federal funds rate, where they forecast the federal funds rate to be. And those insights are particularly important, especially if you’re early in March and you’re looking to see where the Fed thinks rates will be by year end. And the dot plot is released typically at the end of each quarter. So at the March meeting, at the June meeting, at the September meeting and then at the December meeting. 

Cassidy Clement 

So when we’re talking about the Fed or if you’re listening to commentary, reading about it, etcetera, usually there’s a lot of common financial jargon involved. Or I will say, you’ll see it very often in the second you search for the Fed or you’re reading about them. So it will become common very quickly. So I kind of have a lightning round scenario here where I’m going to go down the line for like 5, 6, 7 maybe terms. Could you give our listeners kind of like the bullet point explanations?  

Jose Torres 

Sure! 

Cassidy Clement  

Awesome. So let’s start with the first one. What is monetary policy? 

Jose Torres 

So monetary policy is essentially setting interest rates and whatever bond buying or bond selling program the central bank is engaging in. 

Cassidy Clement 

So another set of terms that we recently did a podcast on is the difference of inflation versus deflation. How would you explain that? 

Jose Torres 

Sure. So inflation means prices are increasing. Deflation means prices are decreasing. And I’ll add one more to that. Disinflation means that the pace of inflation is slowing down. So disinflation means that you still have inflation. Prices are still increasing, albeit at a slower rate. Deflation is when prices are outright declining. 

Cassidy Clement 

What about hawkish versus a dovish Fed policy? 

Jose Torres 

This is one of my favorites because I like animals. So the hawks tend to be folks that have a bias towards more tightening, whereas the doves have a bias towards less tightening, right? So oftentimes whenever there’s disagreement amongst committee members, market participants are always wondering, well, who are the hawks and who are the doves? You know, like in today’s Fed, for example, Harker, from Philadelphia, tends to be dovish, whereas Waller or Kashkari, they tend to be more hawkish. So there’s always market players that like to think about it like that. Like which ones are the hawkish ones and which ones are the dovish ones. And in aggregate, where is that going to shift monetary policy? 

Cassidy Clement 

And that’s also in terms of interest rates, correct. So it’s like a tighter interest rate or like a higher interest rate versus more of a lower policy, right? So the dovish would be lower where the hawkish is higher, correct? 

Jose Torres 

Absolutely yes. 

Cassidy Clement 

So what’s the difference? When you hear these two terms, Federal Reserve versus FOMC? 

Jose Torres 

So the FOMC is the Federal Open Market Committee. And, you know, it refers to the folks that are voting at the Fed meeting. So what happens is that some regional presidents, they have voting rights sometimes, but not all the time. So for example, the New York Fed President- Williams, he votes all the time, but some of the other ones aren’t voting members all the time. So they’ll be like.. I’m not sure exactly how long the terms are, but they’ll be voting for a year or two and then not voting for a year or two like that. The board members always vote and the New York Fed President always votes. The other ones rotate. 

Cassidy Clement  

So the biggest phrase that next to probably monetary policy that comes out of any change in policy usually is the “Fed funds rate _____”, either increased or decreased. What exactly is the Fed funds rate or federal funds rate and how exactly is this looked at? Is it reevaluated every couple of weeks? How exactly does it work? 

Jose Torres 

Sure. So it’s reevaluated at each meeting and then a decision is made, which is then announced to the public on the second day of the meeting at 2:00pm. Then the chair comes out at 2:30pm and has a presentation on economic conditions and a Q&A.  

In terms of what it is and how it affects the economy, it’s the rate on short-term cash and mainly the overnight bank rate. So, if a bank needs cash for example, what’s the rate that that bank needs to pay to get cash in their doors on an overnight basis? So, what happens is that as short-term rates increase, the medium term and long-term rates increase as well. So that’s kind of how the tightening gets dispersed across the entire economy.  

First short-term with the Fed and then ultimately that tightens financial conditions and works its way across the yield curve and then it starts affecting treasury bonds at the five-year to ten-year duration. It starts affecting mortgages, starts affecting car loans, credit card interest rates, all kinds of interest rates, but it starts with that overnight rate that tightens liquidity at the short end and then spreads across the yield curve. 

Cassidy Clement 

Where can some people who are starting investors or just you know, everyday listeners, where can they see the Fed’s impact in their everyday life? I mean, I know the Fed funds rate will impact all types of investment because it impacts market sentiment. But usually where are the key areas that the average adult is going to see the Fed impact their life or their finances? 

Jose Torres 

So, by increasing the federal funds rate, the average adult can park money in financial institutions and gain higher rates. So, for example, I’d invite listeners who don’t already have an Interactive Brokers account to open one, because we’re paying up to 4.83% on idle cash, right? So, that’s one way that folks are affected by higher rates is through their savings.  

Now on the borrowing side, that’s where they’re negatively affected, right? If they want to buy a property, it’s going to be more expensive. If they want to buy an automobile, it’s going to be more expensive. And all the kinds of goods that are usually purchased with financing. Like furniture or microwaves, refrigerators, ovens. You know those heavy household goods become much more expensive to finance at those higher rates. 

Cassidy Clement  

So when these rate decisions come out, is there any general trend of impact on the stock market? Like if a rate goes up, does sentiment usually change or prices change? And in what way? 

Jose Torres

Sure. So typically, the market kind of know what’s going to happen at the Fed meeting. However, there are a lot of cases where there’s a 50-50 split. And in those cases, when Fed chooses the hawk-ish 50%, so in the case, for example, in 2022, prior to some meetings, we didn’t know if it was going to be 75% or 50%. Those were even odds. In the cases where they chose 75%, that led to stock prices going down investor sentiment to sour and to bond for bond yields to go higher. So yeah, generally speaking, if the Fed surprises to the upside with rates that’s bad for financial assets, prices go down. If they surprise towards the downside with rates, then generally speaking that is bullish for financial assets. Stock prices go up and bond yields go down and bond prices go up. 

Cassidy Clement 

So when these meetings or these changes occur, are there are certain indicators that investors should look for in the market or from, let’s say, these meeting recaps? I know you and some of our other commentators write recaps on the meeting or the ripple effects of what happens after the meeting, what should investors be looking for? 

Jose Torres 

Investors should be looking at so many things during a Fed meeting, right? Particularly when the dot plot gets updated. That’s integral because it tells market players where the Fed sees things going in the next few months and how that’s going to guide monetary policy.  

But one of the main things also is the commentary from the Fed chair, right. How’s the Fed chair speaking? Is he pushing back hard against questions, or is he acquiescing to the crowd? What’s the tone? Is the tone hawkish? Is the tone dovish? And that’s kind of how, similar to when listening to company earnings calls, can be very beneficial to investors listening to Fed. The Fed Conference and the Fed presentation is also important from a Macroeconomic perspective, and I would say those are some important considerations. 

Cassidy Clement  

So going one step further, because we’re talking about something that’s US centric, do other countries or other economies really pay attention to the Fed or is that something a little bit more, you know, part of our hometown, if you will or you know, very national instead of international? Are other parties really paying attention to those meetings and these decisions? 

Jose Torres    

Absolutely. You know, the US dollar is the world’s reserve currency. And to the extent that treasury yields increased because the Fed is on a hawkish path, what that actually does is that it brings money from overseas into the US treasury. Because when the US is paying a high rate of interest, that is theoretically risk free.  

And we like to think about treasuries as a risk-free instruments and then we can price all other assets with that consideration in mind. So if someone has an emerging market investment that is going to pay 10% per year with risk, they may not make that investment if Treasury bonds are paying 5.5% because they’re saying, why should I take that risk to get paid 10% when I can get paid 5.5% here without taking risk?  

But as treasury bonds are 1%, then that investor is incrementally incentivized to take that 10% investment. So that’s what happens. When rates go higher, money actually leaves a lot of the emerging markets and they get they go to treasury bonds because of the higher risk-free yields. Again, we have the reserve currency of the world. Another thing, the dollar increases when rates are higher for that reason, right?  

Because of those capital inflows, a dollar becomes more valuable and then that starts to negatively affect exports. Because foreign countries have a more difficult time paying up in U.S. dollars when the dollar is stronger and then a lot of other ripple effects occur as well. But in general, a stronger dollar tightens financial conditions and makes it harder for the rest of the world.  

Cassidy Clement 

There’s a lot of eyes on the US when these meetings go on or when people are reporting on them, so it seems.  

Jose Torres  

Absolutely.  

Cassidy Clement  

Well, all of these were really great, helpful pieces for people trying to put together their first Fed recap and try to understand it. Thank you for joining us. This was great. You had some great insights. 

Jose Torres 

My pleasure. Thanks a lot for having me and looking forward to coming on in the next IBKR podcasts. 

Cassidy Clement 

Sure. So as always, listeners can learn more about an array of financial topics for free at ibkrcampus.com. Follow us on your favorite podcast network and feel free to leave us a rating or review. Thanks for listening everyone!