Why Does the Fed Matter?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Nov 1, 2017 2:32:11 PM

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the FedSitting in the chair that I do, I take quite a bit for granted, not least of which is that things I deal with every day—for example, the Fed—are important. Yet when you stop and look at it, if you are not in the middle of the financial news flow, it isn’t obvious (at least it wouldn't be to me) exactly why that is. Why is there so much coverage of Fed meetings and, at the moment, the selection of a new chair to run the Fed? Today, let’s take a step back and think about why the Fed matters to you and why you should care.

What the Fed does

Strictly speaking, the Fed is the nation’s central bank: the bank that banks use. In the same way you use your bank (deposits, loans, and so forth), other banks go to the Fed. It is not that simple, of course, but is a good mental picture nonetheless. This also sets the stage for why the Fed matters. Just as it matters to you what interest rate you get on your savings and, perhaps more important, what you are paying on your car loan or mortgage, it matters to banks—and therefore indirectly to you—what the Fed is doing with exactly these items.

Put simply, when you go to the bank to deposit or borrow money, what matters to you is interest rates. That is, how much the bank will pay or charge you. Lower rates mean you make less on your savings but that it is easier to borrow, which matters a lot on big-ticket items like cars or houses. With rates low, you are more likely to be able to afford a new car or house and may even borrow more to buy a bigger one. This, in a nutshell, is what the Fed does and why you should care. By setting interest rates, it tries to either stimulate or hold back the economy.

Specifically, the Fed has two explicit jobs: keep prices steady and unemployment low. It attacks these tasks by setting interest rates. Lower interest rates make the country as a whole more likely to spend, which leads to hiring. They can also lead the economy to overheat, however, which can lead to prices rising. The Fed sets interest rates to try to keep a balance between the two. As you can see, they are actually in conflict, so the Fed often finds itself stuck over what to do.

Hawkish versus dovish

This is where the composition of the people who run the Fed, particularly the chair, becomes significant. In deciding which is more important, prices or employment, the Fed can move the economy. People who are more concerned about prices are often referred to as “hawkish,” while those who are more concerned with keeping employment high are referred to as “dovish.” Hawks are biased toward higher rates, whereas doves want to keep rates lower.

With the chair position becoming vacant early next year and other vacant seats available for the president to fill, the question right now is whether the Fed will become more dovish (and likely to keep rates low) or hawkish (and raise rates faster). The right answer depends on how concerned you are about price increases against job growth.

Over the past several years, the Fed has prioritized keeping interest rates low, to keep job growth high, and thus has been seen as dovish. Janet Yellen, the current chair, is perceived as the “queen of the doves.” So, why does Yellen’s successor matter? If the head of the organization were to change from a dove to a hawk, it could get interest rates higher at a faster rate. In turn, that would affect everyone who buys a car or a house, which is to say pretty much everyone.

Stay tuned

We should know this week who the next chair will be and what the Fed plans for the next couple of months. Pay attention. It may be obscure, but it really does matter.

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