The other week the Federal Reserve announced their plan to start unraveling their 4.5 trillion dollar balance sheet. Additionally, they declared that short term interest rates will remain unchanged for the time being. So, what does this actually mean and what impact does it have on you and your retirement preparation?
How did we get here?
In the aftershock of the 2008-2009 recession, the Federal Reserve (basically our nation’s central bank) injected a safety net into our economy. They purchased trillions of dollars of government bonds and mortgage backed securities. For nearly ten years, they’ve continued to reinvest the proceeds as these bonds came to maturity. This process has led to the Federal Reserve building and maintaining a very large balance sheet.
Concurrently to this bond buying program (referred to as Quantitative Easing), the Fed has gradually lowered its short-term interest rate. As of 2016; however, they’ve started increasing this rate again (and have already done two rate increases this year in March and June).
Why did it help?
Many, including myself, believe these tools were paramount to saving our economy. But, why were these two tools so effective?
Purchasing mortgage back securities was a way of securing the real estate market. It offered safety against defaults and took the risk away from banks, investors, and individuals. This, along with purchasing government bonds, injected cash back into our banking system.
Banks with lots of cash enticed individuals to borrow by lowering rates. They did this because they had less incentive to keep cash due to low short term interest rates. When interest rates are so low, there is little incentive to put cash in the banks. We, therefore, saw a massive increase in spending, investing in the stock market, and borrowing for real estate or business ventures. All this served as a catalyst to rejuvenate our economy.
What’s the plan?
Now comes the tricky part – how do they unravel all of this to normalize their balance sheet while not causing a negative shock to the economy? The Fed has to be very careful about its movement while also remaining nimble enough to adjust as needed. They’ve already begun this process by increasing short term interest rates. They are predicting one more later this year and three more increases in 2018. Hopefully the economy is strong enough to handle these higher interest rates as the Fed reiterated that their long-term target Federal Funds rate is somewhere between 2.5-3%.
The other major announcement was to start unwinding their massive balance sheet. The Fed intends to start slow, letting $10 billion a month roll off their books. Eventually, they’ll be increasing it to $50 billion a month. This should have the opposite effect of purchasing bonds (less money in the economy). If you remember your first economic class “supply=demand.” Thus, when there is less money out there the demand (or cost) goes up.
The Fed will always hold substantial assets, so there is no real fear that they unravel to zero. Rather, the plan is to let free markets stand on their own two feet by having less manipulation from the Fed.
What’s the impact on me?
It’s easy to see the impacts of interest rates being low – 15 million jobs added since the recession and one of the longest economic expansions in history. With the recent news about unraveling the Fed’s balance sheet; however, the following thoughts for our clients, their families, and friends should be considered.
- Interest rates should increase in the borrowing market.
Recommendation: If you need to borrow money, or refinance some old debts, now is probably as good a time as ever.
- Stocks and bonds will be affected. Unfortunately, no one really knows how. By going slow, the Fed is trying to provide the least amount of wrinkles through the markets as possible. That said it’s inevitable something this large will have an impact.
Recommendation: Look at your diversification. This is exactly why we diversify; to protect and insulate ourselves from any one segment prohibiting us from reaching our goals.
- The real estate market will be impacted as rates increase. Average purchasers will have to spend less on homes when the rates go up. This can have two outcomes. One is housing prices become cheaper as an entire purchasing pool can afford less. The other is the housing market may continue as is if inflation continues to picks up.
Recommendation: Don’t let the unknown drive a rash decision. A home is a major purchase and I’d hate to see anyone rush on speculation. (For more information on buying readiness, check out Purchasing a House). But, if you are ready to purchase, you might as well. Rates are still historically low.
- Inflation should continue to increase and ideally land at the Fed’s 2% target. With the U.S. labor market being tighter than it’s been in years, it’s surprising that inflation hasn’t been higher. Economists want a 2% level of inflation in an economy. That suggests an expanding economy at full employment.
Recommendation: Bonds typically have a fixed coupon payment, so they carry purchasing power risk since increasing inflation can erode their interest payments. We recommend utilizing a mixed bag of bond instruments. For investors with considerable assets invested in fixed income (bonds), consider using TIPS for a small sleeve as their coupons can increase as inflation rises.
The interesting times ahead
It seems we are getting much more accustomed and immune to unprecedented policy in our economy. We have done a great job as a country of persevering through the best and worst of times. Through the continued “normalization” of the Fed’s policy and balance sheet over the next few years, it should present opportunities and challenges alike. Just make sure you stay educated and keep a long term view.
In his role as Financial Planner, Andrew forges lifelong relationships with clients. He coaches them through all stages of life and guides them to better achieve their life goals. For more information about Andrew or the other firm partners, Kyle Hill and David Levy, click the link below.