Federal Reserve System
Understanding How the Federal Reserve Creates Money
- The Federal Reserve, as America’s central bank, is responsible for controlling the supply of U.S. dollars.
- The Fed creates money by purchasing securities on the open market and adding the corresponding funds to the bank reserves of commercial banks.
- The Fed uses the federal funds rate to affect other interest rates and adjust the money supply.
- To combat the recession caused by COVID-19, the Fed lowered the reserve requirement for banks to zero.
Federal Reserve System
The evolution of finance was different in the United States compared to European countries. In the US, the aversion of legislators to the idea of over-mighty financiers twice aborted an embryonic central bank (the first and second Banks of the United States), so that legislation was not passed to create the Federal Reserve System until 1913. Up until that point, the US was essentially engaged in a natural experiment with wholly free banking. The 1864 National Bank Act had significantly reduced the barriers to setting up a privately owned bank, and capital requirements were low by European standards. At the same time, there were obstacles to setting up banks across state lines. The combined effect of these rules was a surge in the number of national and state-chartered banks during the late nineteenth and early twentieth centuries, from fewer than 12,000 in 1899 to more than 30,000 at the peak in 1922. Large number of under-capitalized banks were a recipe for financial instability, and panics were a regular feature of American economic life - most spectacularly in the Great Depression, when a major banking crisis was exacerbated rather than mitigated by a monetary authority that had been operational for little more than fifteen years. The introduction of deposit insurance in 1933 did much to reduce the vulnerability of American banks to runs. However, the banking sector remained highly fragmented until 1976, when Maine became the first state to legalize interstate banking. It was not until 1933, after the Savings and Loans crisis, that the number of national banks fell below 3,600 for the first time in nearly a century.
Fed and Interest rates
Back during the peak of the Covid-19 pandemic (2020-2021), the Fed kept interest rates near zero to stimulate the economy. Then, inflation spiraled out of control. Then, the Fed aggressively hiked rates for 11 consecutive meetings over the course of 2022 and 2023. Then, once again, the seesaw fell out of balance as the labor market slowed and consumers tightened their belts, slowing economic growth.
In October 2024, the central bank is going for a soft landing, in which the economy is stimulated by lower rates while not slowing enough to send it into a recession. Lower rates means companies should be able to spend more, buying homes will be more affordable, and investors will unleash cash reserves into risk-on assets like equities.
Fed Chair Jerome Powell reiterated that the central bank will be making its monetary decisions meeting-by-meeting and rely on macro data.
The Fed’s updated dot plot now calls for a target range of 4.25% to 4.5% by the end of this year, with policymakers’ median projection 4.4%. That means another 50 basis points worth of cuts this year, which will likely be split into two smaller cuts. The median projected Fed Funds Rate by the end of 2025 is now 3.4%, which would indicate another 100 basis points worth of cuts next year, with the Fed Funds Rate eventually reaching a long-run neutral rate of 2.9% in 2026. However, Powell could easily change course, as the Fed has done many times in the past.
What do rate cuts do?
- Rate cuts make borrowing cheaper for consumers and businesses.
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Business activity: Lower borrowing costs could also spur business activity and a stock market rally as companies would pay less to get cash for new undertakings and expanded hiring. But… a business boom can only happen if the overall economy is healthy.
Rate cuts could provide an electric jolt to the S&P 500.
Stocks love rate cuts
The S&P 500, Treasurys, and gold all tend to rise when the Fed lowers rates, according to a Bloomberg analysis tracking rate cuts since 1989. In fact, the S&P 500 rose an average of 13% in the six months following a rate cut during years where there was no recession.
Turning the clock back even further, the short-, medium-, and long-term market returns after a rate cut are impressive.
“During the five cutting cycles since 1984 where the economy did not quickly enter a recession, the S&P 500 typically returned +6% during the three months, +9% during the six months, and +17% during the 12 months after the first Fed cut,” Goldman Sachs Chief US Equity Strategist David Kostin wrote in a recent note.
Going back even further, since 1980, after each of the 20 times the Fed cut rates with stocks near all-time highs, the S&P 500 was higher a year later, according to Chief Market Strategist at the Carson Group Ryan Detrick.
However, past performance doesn’t guarantee future results. After all, the slowing labor market is an ominous macro indication that things won’t be simple this time around.
And the presidential election this year is a wild card that differentiates this easing cycle from past soft landings. Given the highly charged rhetoric and varying economic policies proposed, the market will likely remain volatile heading into November.
So, while it’s too soon to declare victory quite yet, right now the Powell plane looks all clear for soft landing.
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It is good news for homebuyers in particular:
Mortgage rates have already come down slightly in anticipation of rate cuts.
There might be more open houses to go to. Many homeowners have held off on selling their property since buying a replacement dwelling would involve taking out a mortgage at a sky-high rate.
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Taking out a car loan could get cheaper and credit card APRs might go down, too.
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High yielding savings accounts will stop paying those high interests after rate cuts. Sliding interest rates herald the end of the high-yield savings accounts with returns of up to 5% per year.
The cash cow has been put out to pasture.
Sinking interest rates means some of the sweetest deals rewarding steady savers are coming to an end.
Over the past few years, high-yield savings accounts and other cash equivalents, such as money market funds, offered investors an awesome deal: You could earn a steady 5% return in cash without the risk that comes with volatile equities. That meant crypto bros and day traders had to come to terms with the fact that their cautious peers were making more from sitting in a basic savings account than they were refreshing FinTwit every 30 seconds.
The juice from cash accounts has probably already been squeezed, which means it’s time to figure out where to invest next.
Get off the sidelines:
High-yield savings accounts are a great way to protect your rainy day fund from inflation, and financial advisors across the board recommend keeping about three to six months of living expenses in cash. If you’re saving for a big expense that’s still a few years away, such as a down payment for a home, for example, the pros say that funds are best kept in bonds or CD ladders.
For the long run, right now is the perfect time to lock in longer-term yields from investments like Treasury bonds, according to analysts, in order to secure rates before the Fed announces cuts on Wednesday.
But while it’s tempting to park your hard-earned money in the safety of fixed income, remember that being too afraid of risk can be almost as harmful as taking on too much risk. Cash returns are about to fall back down to earth, and staying on the sidelines means you might miss out on the power of compounding interest in the stock market.
“In addition to managing cash flows for short-term expenses, investors should hold a portfolio that aims to meet their financial objectives over a lifetime,” explained Solita Marcelli, CIO Americas at UBS, in a note today. “The focus, in our view, is to produce consistent growth and income to ensure that their lifetime spending needs will be met, even if there is a stretch of volatility or poor market returns.”
While your portfolio is yours to design, be aware that in the years to come, you won’t be earning the same risk-free returns in cash that you’ve recently enjoyed. While stocks are volatile, they pack a punch over time. So dive back into equities, the water is warm.
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Mergers and acquisitions: Cheaper loans could lead to more mergers and acquisitions, benefiting investment banks like Goldman Sachs that facilitate these transactions.
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Banks’ consumer lending units will take a hit: Banking giants warned that lower rates could hurt their consumer lending units since they’ll make a smaller profit on auto loans and mortgages.
How to invest in the housing market?
Lower interest rates means lower mortgage rates, which should translate to increased demand for new homes in the coming years. That directly benefits homebuilder stocks, and the companies building homes know it.
Lower mortgage rates should also boost homebuilders because it makes it cheaper for them to borrow in order to fund construction.
The S&P Homebuilders ETF (XHB), for example, has already jumped about 26% this year so far (in anticipation of the rate cuts).
Analysts from RBC Capital believe stocks like Taylor Morrison Home, Toll Brothers, and Tri Pointe Homes have room to run even further.
However, the sector will have to rise to meet the high expectations investors already have. So while optimism is sweeping markets ahead of a rate cut, caution is still warranted.
How to invest during a time of interest rate cuts by Fed?
Historically, rate cuts have given equities a boost.
Fine-tuning your portfolio to best position yourself for this massive economic shift will set you up for gains in the months and years ahead.
Here’s how to invest in a world with lower interest rates:
Small caps
Since smaller companies usually carry more debt compared to their larger peers and are therefore more sensitive to borrowing costs, they should get a boost. They also rely more on outside financing, which becomes more affordable with lower rates.
However, large-cap growth stocks will also benefit. Investors who’ve kept cash waiting on the sidelines will be using it to buy top performers. Analysts at UBS identified Oracle (ORCL), Dayforce (DAY), and Braze (BRZE) as fairly priced picks in a recent note.
Energy
Analysts point to energy as one sector that’s well-positioned for a jolt to economic growth, especially considering the sector’s recent downturn amid geopolitical instability. Morgan Stanley analyst Devin McDermott selected Energy Transfer L.P. (ET), ONEOK (OKE), and Plains All American Pipeline (PAA) as his overweight picks.
Real estate
This interest rate-sensitive sector tends to get a boost from lower rates, since housing market activity should accelerate thanks to more affordable mortgages. Within real estate, Morgan Stanley analysts are overweight SBA Communications (SBAC). Some homebuilding stocks are also set to benefit.
Defensive sectors
Morgan Stanley Chief Investment Officer Mike Wilson argued in a recent note that defensive picks are better positioned for lower rates than cyclicals. He’s especially a fan of Utilities, and is overweight Public Service Enterprise Group (PEG)within that sector.
Consumer staples
Businesses aren’t the only ones spending more now that rates have been cut. Consumers should open their wallets, as well. According to a CNBC analysis, many of the stocks that performed best after previous rate cuts were consumer-facing favorites: Nike (NKE), Walmart (WMT), and Tyson Foods (TSN) were all top gainers.
Bottomline:
Just because a certain sector soared after a previous rate cut doesn’t necessarily mean it’ll happen now. And even analysts themselves disagree about what corners of the stock market are set to gain. While Wall Street expects volatility over the coming months as investors get used to the new rules of the game, don’t get spooked, and stay the course.
TODO
- What’s Ahead For The Federal Reserve In 2025? https://www.investopedia.com/what-s-ahead-for-the-fed-in-2025-8765271
- What’s the Outlook for Interest Rates in 2025? https://www.investopedia.com/interest-rates-outlook-2025-federal-reserve-mortgages-car-loans-credit-cards-8764416