Money is half of every transaction, so whenever a characteristic of the money itself is influenced, it can have a large effect on the populous as a whole. The purpose of this post is to give further clarification on how monetary policy affects consumer spending and general factors that the Fed uses as indictors to alter their policy stance.
Interest rates
As we already know, the Federal Reserve does not directly change interest rates. They do, however, influence short-term interest rates by changing the Fed Funds rate and the Overnight Repurchase Agreement rate. The Fed funds rate refers to the interest rate that commercial banks can charge other depository institutions at the Fed for lending excess reserves overnight. Fed Funds is typically not just a single interest rate. More accurately, it is a target range which the FOMC sets and changes with the aim of influencing short-term interest rates.
It is expected that short-term interest rates will follow Fed funds, meaning if Fed funds decreases, so will short-term interest rates, and conversely, if Fed Funds increases, so will short-term interest rates. As of this writing, the Federal Reserve has finished tapering their asset purchases (Quantitative easing), and they are planning on raising interest rates during the next FOMC meeting. One reason investors pay attention to the Fed’s future plans with Fed Funds is because in theory, shifting the Fed Funds rate higher or lower should also shift the yield curve in the same direction (via influencing short-term rates). It is believed by some that asset prices are directly tied to interest rates because interest rates are the price of borrowing money. Now, superficially this makes perfect sense, however, there are a lot of cross currents when it comes to asset prices, so to believe that asset prices will increase just because interest rates are lowering or that asset prices will decreases simply because interest rates are increasing seems rather naïve. Interest rates are definitely one of the crosscurrents affecting asset prices, but they certainly are not the entire picture.
Below is a chart of the Fed Funds rate from 1995 to 2020. Note how it significantly decreases, sometimes literally straight down, when a major recession hits or massive asset bubble pops. Examples would be the Dot Com bubble (shown with 1999 to 2001 decrease), Global Financial Crisis and Real Estate bubble (2007 to late 2008), and from the recent pandemic in 2020 where fed funds literally dropped down to zero overnight. It is also very important to note that Fed Funds was essentially zero-bound from 2009 to 2016. It seems like the range was 0 to 25 basis points (0% to 0.25%) for the entire Obama presidency.
Effects on spending
Remember that the Federal reserve has a dual policy mandate for maximum employment and price stability. I want to make this distinction because the Fed Funds rate pertains to member institutions of the Federal Reserve system, and that does not include individuals. So, by the Federal reserve setting the target range that commercial banks may lend their reserve to each other, they are setting a minimum for interest rates, at least psychologically. Think of it from the perspective of the bank, if you can lend to another bank and get specific yield, say 0.25%, then why would you lend to a small business or individual for less than that, you wouldn’t because it wouldn’t be a smart decision. Why would it be unwise? Because of counter-party risk. That person or business you lent to needs to pay you back, or you don’t get that yield. A major factor of lending (and currency) is country party risk.
Now, the why happens when the banks won’t even lend to each other at that interest rate because they do not trust the other bank as a counterparty. Cue the federal reserve. The Fed created a reverse repo facility just for this. This is where the ON RRP rate comes into play (Overnight Reverse Repurchase Agreements, henceforth called reverse repos). Now those commercial banks with trust issues (probably merited) can lend their reserves to the Federal reserve for some assets they can use as collateral (like U.S. treasuries). This is important from a counter-party risk perspective because with the Fed as your counter party the risk of default is significantly decreased, possibly even zero. It’s hard to default on a loan when you can literally just “print” the money that is needed to pay back the loan. This leads on to the idea that reverse repo rate is a reflection of the liquidity in the financial system, and any spike in the ON RRP rate reflects a liquidity freeze.
The preceding two paragraphs are meant to provide some context as to how Fed funds affects individuals. Since consumers have a much higher risk of default than the Federal reserve, commercial banks will charge them a much higher interest rate to borrow money. This then affects their spending decisions which in turn influence macroeconomic factors like the production of goods and services, employment, and inflation.
One of the things I have noticed about Keynesian economics is that it seems very demand focused. Inflation is because of an “over-heating” economy with so much productivity that demand is soaring and therefore prices rise. When there is a recession, demand decreases and therefore the government must step in and artificially increase demand, either by fiscal spending or government transfer payments. This is one of the arguments for lower interest rates whenever the economy starts to falter. By decreasing interest rates, people and businesses can borrow more than before without increasing the price they need to pay for the debt (increase in purchasing power), therefore they can spend more which increases demand. Also, with lower interest rates the yield an individual receives by saving money in a bank account decreases as well, creating a larger incentive to spend money and not save because they are not being paid as much to save in the first place. This is especially true when inflation is much higher than the interest rate on savings accounts because people intrinsically understand that they are losing purchasing power by saving money. This incentivizes them to borrow and spend, thus increasing demand even more.
Below is a bar graph of the relationship between mortgage interest rates and the purchasing power associated with them. This assumes a conventional loan with a 20% down payment and a monthly payment of about $1500. As you can see, to maintain the same monthly payment there is a difference of about $90,000 in housing price between the interest rates of 5.5% and 3.5%. Meaning by your mortgage rate decreasing 2% from 5.5% to 3.5%, you can by $90,000 more without increasing your monthly payment. That incentivizes people to buy larger homes. Now, this isn’t a bad thing necessarily, it is just that the knock-on effects down the road and other things that are influenced by interest rates can get very messy. I just wanted to use this as an example of the incentives are play. As I believe Charlie Munger said, “show me the incentives, and I will show you the outcome.”
Factors affecting the stance of monetary policy
There are three broad categories of factors that affect the Fed’s stance on monetary policy: anticipated factors, demand shocks and supply shocks. These are relatively self-explanatory. Anticipated factors are events and things that are, well, anticipated. Changes to the tax code is one example of this because it is public information, meaning the Fed has easy access to it, and we can easily find out how it is doing on its journey of becoming legislation.
From more of a real economy perspective, supply and demand shocks are pretty common sensical as well. Demand shocks are shifts in consumer and business behavior or unexpected alterations in lending standards from banks and other lenders. This leads to a shock to demand, meaning the demand for a good or service has a sudden, disorderly, and significant increase or decrease. In other words, the price of a good or service goes to the moon or falls through the floor due to a factor that is demand related.
On the other hand, supply shocks are a slowdown in the growth of supply or productivity of a particular good or service relative to what would normally have occurred. An example of a supply shock is a shortage of any kind. So, if there is a massive drought throughout the entire Midwest that kills a lot of the corn, wheat, and soybeans, then there will be a shortage of those commodities until we are able to find them somewhere else or have enough in reserves (if having reserves of crops to a significant degree for a long period of time is even possible, due to their perishability). It seems the typical response from government is to counter the loss by easing monetary policy and therefore making financial conditions more accommodative to spending. This increases demand, but the problem is there is no supply for the good or service. Just throwing money at the problem isn’t going to always bring about more supply, at least in and of itself. The Farmers are already incentivized to make as much money as they can and will tailor their production accordingly by finding the optimal amount to produce so they can receive the highest price they can without creating an oversupply. It also takes time to grow crops, so it doesn’t seem apparent that government spending would in and of itself fix the problem that the free market would not have done anyway.
Final Words
As a part of the closing thoughts, I would like to point out that there is a lag between a change in monetary policy and how it will manifest in the real economy. We can look very recently for a great example of this pertaining to consumer price inflation. With the advent of government transfer payments in April of 2020 (stimi checks), it took over 6 months to a year for consumer price inflation to really break trend. Below is a graph of the Consumer Price Index for All Urban Consumers (CPI-U). This is a monthly percentage change chart, not the annualized version, which is why the y-axis (on the left) is not larger than one percent. As you can see, the CPI-U seemed to be range-bound (0 to 0.5%) from January of 2012 to the beginning of 2021, barring a few single month spikes (i.e., March 2020). However, it seems the trend had broken out of the range starting in January of 2021. That is 8 months after the first round of government transfer payments. Discussion of possible explanations for this breakout are not within the scope of purpose for this post, so I will punt on this one as well. Again, I am just using this to illustrate a point, in this case, that there is a lag between policy changes and their manifestation in the real economy, sometimes a rather long one.
To your wealth and future,
James Forsythe
For more on the Importance of Monetary Policy
https://jamesdforsythe.com/role-and-importance-of-monetary-policy/
For more on the CPI and Inflation
https://jamesdforsythe.com/best-measure-of-inflation-the-consumer-price-index-cpi/
https://jamesdforsythe.com/how-does-inflation-affect-a-household-and-how-to-protect-yourself/
