Recognized as the most powerful central bank in the world, The Federal Reserve or “Fed” with its governing of monetary policy deeply impacts the decisions of global financial institutions and other investors ranging from high-net-worth individuals to family offices, and this blog post digs deeper into that.
The Federal Reserve functions primarily to regulate monetary policy in America by either raising rates to squeeze inflation (characterized by progressively higher prices) or decreasing interest rates to combat deflation with converse effects (lower prices). All else being equal, a higher federal funds rate reflects faster economic growth, fiscal weakness/instability and higher inflation. On the flip side, a lower federal funds rate reflects slower economic growth, fiscal strength/stability, and lower inflation.
As a first principle of market function we understand that when the cost of capital is less than the return on capital asset prices rise over the long-term and conversely when the cost of capital is higher then the return on capital asset prices move lower. And essentially, the greater the spread or difference between the cost of capital and return on capital the greater the magnitude of the increase or decrease in asset prices.
But at the same time, it’s important to understand that in the short term asset prices are buoyed more by the popularity of issues and the pervasive sentiment governing markets. Nothing is set in stone and the world is changing by the minute if not second, so you always have to keep that in mind.
Lately we have been getting a lot of questions related to interest rate cuts by the Fed, which can be a catalyst for a shift in the asset allocation for family offices and institutional investors alike, which is one of many science experiments we’re always running in tandem.
And below are some of the common questions:
What would happen if the Federal Reserve lowered the rates?
In theory all else being equal, a lower federal funds rate should reduce borrowing costs and inflate asset prices over the long term as the cost of capital declines, but since markets are irrational in the short term we must focus on aggregate market positioning and market price action to interpret the market’s message in the face of lower rates.
What are the effects of the Federal Reserve cutting rates?
The federal funds rate directly influences the interest rates set for consumer loans, credit cards, real estate loans, the risk-free rate of return, corporate bonds, municipal bonds, government bonds and a plethora of other lending activities in the financial markets, and cutting interest rates generally reduces the cost of borrowing for consumers, investors and financial institutions.
How exactly does the Fed impact financial markets?
The Federal Reserve has a dual mandate: Pursuing price stability and maximum employment and by balancing/shifting interest rates in the face of inflationary pressures and deflationary stress, the Fed impacts financial markets in a multitude of ways.
Who benefits from rate cuts?
Borrowers, debtors and equity investors typically benefit most from rate cuts as this decreases their cost of capital for all financial transactions: A perfect example is a real estate investor purchasing a large commercial property with borrowed money will have a lower debt service cost or cost of money when interest rates fall.
Another thing to note is that lenders, creditors and bond investors typically benefit least from rate cuts as the interest rate payments they receive from their lending activity typically goes down.
The moral of the story is that the financial space is like the Wild West and there’s no definitive solution that always generates a win so all you can do is make the most educated decisions based on the best data/insights available to help navigate the wide range of potential market outcomes. And if you have questions, let’s connect.