By Ryan Remiggio
Janet Yellen, the chairwoman of the Federal Reserve System whose words have the power to sway the market in many directions, spoke Sept. 17, regarding the outlook of the economy and more importantly, the Federal Funds Rate.
Everyone waited anxiously at 2:30 p.m. for Yellen to tell the world whether or not the Fed has decided to start pulling back on its easy-money policy which would increase the Federal Funds Rate. This rate, which is the interest rate that banks are charged to borrow overnight from each other on money that they hold with the Fed, is the most important rate of all because it essentially sets the levels of all other interest rates in the U.S. economy. Using what is called monetary policy, the Fed can manipulate two variables: interest rates and money supply in the economy. By buying U.S. Treasury Bonds, the Fed is putting more money into circulation. This makes money easier to obtain, which lowers interest rate, but at the same time raises inflation. It is good to know that money supply and inflation rate are, for the most part, directly proportional, and that same inflation is healthy for the economy.
The Fed has been enacting a Monetary Policy for many years now and this has kept the interest rates to near 0 percent so that the economy could recover from its collapse in 2008. Only two minutes into her speech, the S&P 500, an index that is used to gauge the performance of the financial markets, started to fall as her introduction did not bode well to viewers. This could be mostly attributed to Yellen stating that the Fed was going to make another reduction in its asset purchases (these include the Treasury Bills and other instruments from $25 billion to $15 billion a month for three months). You may ask, “Why would this make the market index fall?” It is largely due to the fact that most companies love these low interest rates and, at first, this statement seemed to indicate that rates could start rising soon. When rates are low, companies can borrow to expand and take on projects by issuing bonds or using other methods, and they will not have to pay back their borrowed money with high interest. The S&P fell for roughly 18 minutes by about 5.45 points from 2007.41 to 2001.96.
Throughout the speech, Yellen continuously used the phrase “considerable time” to reference the amount of time before interest rates would rise towards normal levels. This seemed a bit confusing to those watching the speech because viewers were unsure as to how much time “considerable time” represented. Yellen also stressed that rates could be increased sooner than expected if positive economic health permits. This was not clarified until about twenty minutes into her speech when someone in the audience asked for a quantitative value for “considerable time” to which Yellen responded, “I want to emphasize that there is no mechanical interpretation of what the term ‘considerable time.’” This seemed to be favorable to the market, because as you can see from the chart, the S&P rose all the way to 2010.43 (an 8.47 point rise) for the duration of the Q&As.
Of course, Yellen covered three other very important topics in her speech regarding the outlook of the economy and some of its variables such as unemployment rate, inflation rate and real gross domestic product (GDP) growth. Two major goals of the Fed are to maintain a maximum sustained employment rate and to increase inflation to its target range of 2 percent.
As Yellen mentioned throughout her speech when referring to the labor market, “Job growth has slowed recently,” but job gains averaged about 200,000 per month in the past three months leading to an unemployment rate of 6.1 percent in August (2/10 lower than the data available at the time of the Federal Open Market Committee’s June meeting). Indeed this is a gradual progress, but there is an “underutilization of labor market resources.”
In Yellen’s words, there are “too many people that want jobs but cannot find them, too many who are working part time but would prefer full employment, and too many that are not searching for a job but would be if the job market were stronger.”
Keep in mind that unemployment rate only takes into account those in the labor force, which means the unemployed must be actively looking for a job in the past four weeks. Otherwise, they are not in the labor force, making this rate a somewhat inaccurate representation since workers can easily become discouraged.
She then went on to state that economic activity has expanded at a moderate pace, due to an increase in consumer and business spending, and is expected to continue this moderate pace. Real GDP growth was 2.0-2.2 percent for 2014, down slightly from the June projections but over the next three years, it should run above the estimates of long run normal growth. As was stated before, the Fed’s target inflation rate is 2 percent (currently at 1.6 percent for 12 months ending January 2014) and the monetary policy that is still in effect is the primary way to increase the money supply; keep in mind that money supply and inflation rate are positively related. However, the Fed predicts inflation will rise closer to its 2 percent target and a large improvement in the labor market, it will discontinue this policy at its next meeting.
As a finance-oriented writer, this article has to have something more to do with the market. So you may be wondering, “What does this mean for my stocks?” Well, historically speaking, past interest rate hikes have increased stocks about 6 percent after about a year of the increase caused by the internet bubble burst in 2000, according to Goldman Sachs. But realistically it is not what the Fed does that is important, it is why the Fed does what it does. It reacts based on how the economy is doing, and since it states that it will begin to increase interest rates in the near future, it is an indicator that the economy is doing better. At the same time, one should be aware that the economy is operating below the Fed’s original growth estimates, which could indicate a reduction in America’s economic potential.