Much Ado about Next to Nothing
How the Fed’s near 0% rate policy will affect borrowers and savers in the years ahead
By Kerby Meyers | October 14, 2020
Since 1978, the Federal Reseve Bank of Kansas City has hosted central bankers, policymakers, academics and economists at an annual end-of-summer gathering at Jackson Hole, Wyo., to discuss the world’s pressing economic issues.
In August, the pandemic drove the group online to tackle this year’s theme, “Navigating the Decade Ahead: Implications for Monetary Policy.” To kick off the discussion, U.S. Federal Reserve Chair Jerome Powell unveiled the first significant change in the central bank’s fundamental strategy since 2012.
Instead of setting a 2.0% U.S. inflation rate as a ceiling, the Fed now targets the 2.0% level as an average goal, which could allow for it to rise as high 2.5% for limited periods of time. While a half a percent here or there might not sound like much, the subtle shift in policy has downstream effects that will impact us all for years to come.
Three weeks later, the central bank shared more directly what that will look like in the coming years: its key overnight lending rate will remain at or near 0% through 2023.
“These rate-lowering actions mirror what we saw in 2007 and 2008 during that economic crisis, just much more abrupt,” said Scott Grauer, head of BOK Financial’s wealth management division. “Following that event, near-zero rates lasted for seven years, until 2015.
“Barring extreme inflationary pressures, we expect this to be another long-term trend,” he added
Extremely low interest rates put a different spin on the nation’s financial markets than we’ve grown accustomed to over the years. Borrowers and investors must consider how to best balance their goals with their tolerance for risk while navigating the new realities, including:
Personal and business loans
Mortgage rates dropped below 3% in the wake of the pandemic, sparking a refinancing wave and helping fuel strong housing market demand, said Steve Wyett, chief investment strategist with BOK Financial. Auto loans also benefited, he added, although credit card rates were largely unaffected.
As commercial loan rates also fell, many businesses took advantage to keep operations afloat during the downturn or refinance older loans with higher rates.
The flipside of record-low borrowing rates is tiny bond yields, and when the Fed’s baseline is 0%, fixed-income investors must scramble to find decent returns.
As a result, many assume higher risks than usual to generate at least a portion of the periodic payments that they normally associate with bond investments. “When the 10-year U.S. Treasury bond yields 66 basis points (0.66%), that’s not really risk-less return, that’s more like return-less risk,” Wyett said.
Historically, lower bond yields support rising equity values as investors gravitate toward the asset class that will likely offer better returns. In addition, company growth rates tend to benefit greatly from reduced funding rates, Wyett said.
Expanded demand for dividend-paying stocks, which investors may turn to when bond yields are low, have further boosted demand for stocks this year. Given how quickly equity valuations climbed through the summer, however, Wyett cautioned that a lack of proportionate gains in corporate earnings introduces a new specter of risk.
How we got here
The U.S. entered 2020 on fairly stable footing, with expectations for continued economic growth, albeit slower than some preferred, and rising corporate earnings. The Fed’s three interest-rate cuts in 2019 helped fuel optimism that the country would extend its 10-year economic expansion.
“The outlook in January of this year could be characterized as benign,” Wyett said. “Of course, risks are always present and we were starting to get some questions about the length of the expansion that emerged from the 2009 recession, but we weren’t seeing a lot of hallmarks of an economy going into a recession.”
COVID-19 changed all of that.
Forcing an abrupt and wide-ranging shutdown of all but the most essential of businesses, the pandemic’s onset in the U.S. in March sent financial markets into a tailspin. Every type of investment outside of U.S. Treasury bonds plummeted in value, millions found themselves suddenly unemployed and the economy seized, shrinking 32.9% in the second quarter.
“The level of uncertainty that the pandemic introduced was unprecedented, as was the country’s reaction to it,” Wyett said. “But in response, the Fed and Congress acted very quickly to help bridge the gap and keep the impact of this economic shutdown from being nearly as bad as it would have been without their prompt actions.”
Congress passed the Coronavirus Aid, Relief, and Economic Security, or CARES, Act, which provided direct relief to businesses, workers and families. And the Fed quickly cut its key lending rate to virtually 0%.
Then, to ensure that the historically low rates carried through to borrowers, it unleashed a series of bond-buying programs designed to support assorted bond issuers.
“The Fed has a lot of tools that they can use to spur economic activity,” Wyett said. “Monetary policy, however, can be a blunt instrument at times and sometimes all they can do is swing their hammer harder. In cutting rates to 0%, they swung their hammer pretty hard.”
In short, the Federal Reserve controls the U.S. money supply. Setting its key lending rate at 0% means banks and other financial institutions may borrow from the Fed at essentially no cost.
By explicitly laying out its game plan for the next three years, the Fed offered borrowers and investors a rare sense of certainty about the near-term outlook for interest rates. Yet, it’s as critical to account for the potential risks as much as the possible benefits.
“Understanding your financial situation and the areas that need to be reassessed in light of changing interest rate policy is critical to maintaining your financial direction,” Grauer said.
“Coming out of the longest expansionary market in history, this abrupt recession and reaction by the Fed caught many DIY investors off guard. True financial planning, now more than ever, is critical for financial success.”