How Federal Rate Affects Investors
One of the things that kept me thinking before when I was starting as an investor is the Federal Rate. Why is it so important? Why do the whole world of investors look at it too much? And how powerful is Ben Bernanke to control and manipulate it?
We can see that a lot of times, if there was a federal rate cut, stocks will go up and rally. What’s in the federal rate cut that makes stock investors happy? And why is the Fed now continuously cuts it reaching record breaking lows of just 0.5%?
Before anything else, first of all, what is the federal rate? Federal rate is the rate used by the Federal Reserve to lend money to banks, usually overnight. A bank borrows capital from the Federal Reserve and the interest rate of the capital borrowed is the Federal Rate or FED RATE. The bank then will offer loans to borrowers at a much higher interest. The difference between the fed rate and the interest rate of the loan will then be the earnings of the bank. An example of this is: If the FED Rate is 2%, the bank will use 5% as interest to lend money to borrowers. The difference of 3% will then be the earnings of the bank.
Who determines the federal rate? It is being decided by the Federal Open Market Commitee or FOMC in their meetings and currently chaired by Ben Bernanke. There are many economic factors that contributes to their decision such as unemployment rate, consumer confidence index, inflation rate, etc. A low federal rate may increase inflation rate because this means that there is a lot of liquidity in the market. Too much money in the market will increase prices of commodities. Remember the law of supply and demand. Banks can easily borrow at a low interest rate from the Federal Reserve and therefore can easily loan it to borrowers. In contrast, a high federal rate makes banks harder to secure loans from the Federal Reserve. In effect, the economy may suffer as there will be less loans to be offered to borrowers which in turn they can use to fund their business. Without businesses operating, there will be an increase in unemployment rate and a lower consumer confidence level which may retard the growth of an economy.
Now, why is it that the federal continuously cuts interest rates nowadays? Simply because of the credit crunch crisis. They need to pump prime the economy to move it forward since there are too little liquidity in the market nowadays as an effect of the subprime mortgage crisis. Liquidity is stocked in foreclosed houses with no willing buyers and to those investments such as company bonds with depreciating values.
And why do stock investors usually cheer when there are federal rate cuts? Because it serves as a signal of liquidity. With the federal rate cuts, borrowers can easily borrow to finance their businesses and in turn provide employment opportunities. It will pump prime the economy. And of course a profitable business signals a profitable return for stock investors.
But how come even there was a series of rate cuts not only by the Federal Reserve but also by the other major central banks in the world, still the stock market is reaching record lows now? I guess we are in a deep global financial crisis. Investors fear that the worst is yet to come. The effects of the subprime mortgage crisis is too deep that led major companies such as Lehman Brothers and Washington Mutual filed bankruptcies.
I hope that this crisis will be over soon as I am also an investor invested in the stock market.
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