Fed Terminology 101

by | 26 Feb, 2019

 

The US Federal Reserve has had always had an incredibly important role to play in global markets, but how do you cut through all of the jargon and get to the meat of what’s going on?

If any of you have done economics at school or university, then you’ll be familiar with the monetary policy and the role of the central bank in the economy. If not, then today is your lucky day because understanding what the Fed is doing will undoubtedly help your investments!

 

Breaking through the Jargon

If you’ve watched or read about announcements from central banks then you would have seen the terms ‘dovish’ and ‘hawkish’ thrown about in conversation. Now while economics can be somewhat of a zoo at times, these are not referring to real animals. Both terms describe forms of monetary policy, the first expansionary and the latter contractionary. But we’ll get back to that once we’ve established what Central Banks are actually responsible for.

The central bank itself is tasked with keeping with keeping inflation in a manageable range so that prices do not get out of control and that the country grows at a sustainable rate. It achieves this by using its favourite tool – interest rates.

Interest rates should be a familiar concept because if you’ve ever taken out a loan then you would know that the interest rate is the price you pay for borrowing money. The central bank uses interest rates as part of its monetary policy to control the amount of money circulating in the economy. Too much money in the system causes inflation, but too little money cripples growth.The central bank tries to find a happy medium between the two by increasing and decreasing interest rates to find the optimal level for the economy.

 

What are the effects?

Increasing interest rates makes money more expensive to borrow or hold which reduces loan-holders’ disposable income and disincentivises more people from seeking loans at the new, higher prices. Higher interest rates also means that bonds become more valuable and the opportunity cost of holding cash increases, making people happier to stick their money in the bank to earn a better rate on it instead of spending it. This sucks money out of the system, slowing consumption and subduing growth when things are moving too fast. The central bank is said to be ‘hawkish’ when it increases rates because a hawk is known for its aggression, speed and and harshness which can be likened to an increase in the cost of borrowing.

Decreasing interest rates does the opposite by making money cheaper to borrow. This induces people to spend and consume more which in turn drives growth by injecting money into the system when things are moving too slowly. Lower interest rates also means that bonds become less attractive and the opportunity cost of holding cash decreases, making people more likely to spend it than put it in the bank.The central bank is said to be dovish when it decreases rates because doves are generally seen as a sign of peace and tranquility which can be compared to the feeling of ease when the costs of borrowing are lower.

 

What happens in the markets?

In general, a decrease in interest rates is good for stocks. Consumers have more disposable income to invest in the markets and spend in stores. Companies also have greater access to loans for development capital which in turn helps them grow more. The opposite holds for an increase in rates.

In the currency market an increase in rates makes that country’s currency appreciate in value as foreign investors buy its higher interest rate bonds. This in turn boosts the currency as foreign investors must change their currency into domestic currency to buy the bonds.

A shift in monetary policy affects the whole country and sometimes even the entire global economy. Given that many countries hold debt denominated in dollars, a change in monetary policy in the US will affect any country that holds debt in two ways.

1) The cost of holding debt (interest rate) is higher, making repayments more expensive.

2) The dollar appreciates which makes the debt more expensive in that country’s domestic currency.

It’s a scary double whammy which hurts the most indebted and currency sensitive countries the most which tends to be emerging markets. 2018 was a great example of the power of higher interest rates to squeeze growth in emerging markets which fell considerable towards the end of 2018 as the Fed tightened its rates, then came back when it put the rate hike cycle on pause.

 

What’s the Moral of the Story?

Understanding the Fed and central bank jargon is extremely important as an investor because the slightest change could impact your portfolio considerably. So, when the Fed speaks you listen!

 

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