By Jordan Toy, CFA

“We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, it’s production, jobs, and price stability” Alan Greenspan, Federal Reserve Chairman, 5 December 1996
For the past year or so interest rates have been front page news and have had a huge impact on most investment portfolios so its worthwhile understanding how interest rates are set, who sets them and why. While it may seem boring, interest rates are essentially the cost of money and impact everything from borrowing and lending to the discount rate used to value stocks – they’re an integral part of the modern financial system and have far-reaching impacts. Anyone who has listened to an economist speak, knows that topics such as interest rates can seem and often are complex – I’ve therefore distilled this topic down to a simplified, more palatable format.

But before diving into the interest rate setting process let’s take a step back and understand the context that this takes place in. In most countries, interest rates are set by central banks or reserve banks which are typically independent national authorities that set monetary policy as well as regulating the commercial banking sector. The independence of central banks is absolutely vital to ensure that they can focus on the health of the overall economy and to remove them from the whims of politicians – who are usually more concerned with their own prospects of winning the next election than the longer term health of their country’s economy. These may sound like they should be two very aligned topics but unfortunately, they are often not. Politicians frequently interfere in the economy, making short-term decisions that are focussed on delivering a ‘quick win’ to garner popularity ahead of an election with little concern for the longer term impacts of these short-term decisions as they likely won’t be around that long to worry about the consequences. A good example of this is climate change – in the past twenty years or so why would a politician worry about climate change when giving an economic advantage to energy companies is much more certain to deliver a near immediate economic and political win? But I digress, in a nutshell, central banks need to be independent so that they can make the best decisions for the economy irrespective of whether it helps or hinders the incumbent political party.

In almost all cases a central bank’s key objective is to maintain the stability of the financial system in their country. In the case of the USA, their central bank is called the Federal Reserve which has goals, set by Congress, of achieving maximum employment, stable prices (this talks to managing inflation) and moderate long term interest rates – all of which essentially talk to the stability of the overall financial system. While most countries have central banks, they are not all created equal and as you can imagine, the US economy is a force to be reckoned with in the global economy and accounts for a large portion of global GDP and trade. Add to this increasing levels of globalisation over the past few decades and you can begin to understand how the world’s economies are intricately linked and therefore the actions of the central banks of the world’s largest economies can have an outsized impact on all nations’ economies. Therefore, the actions of the US Federal Reserve reverberate around the entire global economy and are worth paying attention to no matter where in the world you live.

Now that we have a better understanding about what a central bank is, what do they actually do? A central bank is often considered to be a bank for other banks and much like the banks that you and I have savings accounts at, your bank will have its own account with your country’s central bank. Going a step further, similar to how you may deposit or borrow funds from your bank, your bank will also deposit and borrow money from the central bank. This leads into my point about central banks being responsible for maintaining financial stability because during periods of market stress central banks will often step in to act as a lender of last resort when otherwise healthy banks face difficulties that pose a risk to the entire financial system – sound familiar? It should because this is exactly what happened in the Great Recession of 2008 when many US banks were teetering on the edge of financial ruin. Yes, some banks did fail (think Lehman Brothers) but others needed to be saved for the sake of the US economy and the Federal Reserve did step in. Bear Stearns, Citigroup and Bank of America to name a few, were all deemed too big to fail and were bailed out by the Federal Reserve due to the risk they posed to the US financial system.

Now interest rates, for those not so familiar, interest rates in the US are set by a Federal Reserve committee called the Federal Open Market Committee or FOMC for short. This committee meets regularly, assesses economic conditions and then sets an appropriate level for interest rates until their next meeting to ensure they keep the economy in check and in line with the Federal Reserve’s objectives (mentioned above). This interest rate setting function is critical as it is one of the primary mechanisms through which reserve banks can influence the economy. Unfortunately, it is a relatively blunt tool and can have unintended consequences due to the fact that it affects most aspects of economic activity. Once these meetings are concluded the FOMC releases a statement as well as their “Summary of Economic Projections” (only released every two meetings), this is usually then followed by a press conference – and all of these can be market moving events!

Within the Economic Projections document is a chart called the Dot Plot (you’ll see the most recent chart below). You may have heard of this, but few investors look at this chart and even fewer understand what important information it can provide. Each dot represents one FOMC member with the Y (vertical) axis indicating the interest rate level and the X (horizontal) axis showing the year for which each FOMC member gave their forecast. This chart therefore gives us an indication of each committee member’s views on the future path of interest rates and provides the market with a glimpse of where interest rates may be headed in future. I emphasize “may” because in the words of the Chairman of the Federal Reserve, Jerome Powell “Dots are to be taken with a big, big grain of salt” and “They’re not a committee forecast, they’re not a plan. The dots are not a great forecaster of future rate moves. And that’s because it’s so highly uncertain.”

What he’s alluding to here is that things change – economic data could look more or less favourable at the next meeting which could lead the FOMC to alter their views (and update the dot plot). While the dot plot shouldn’t be treated as a forecast it does provide some insight into what the committee members are thinking and gives the market a general direction on where rates are likely headed and what the impact could be on their investments. The FOMC meets again in a few days on 13-14 December 2022 and will provide an updated dot plot.

FOMC participants’ assessment of appropriate monetary policy: Midpoint of target range or target level for the federal funds rate

Source: Federal Reserve Summary of Economic Projections – 21 September 2022

So, we’ve looked at the specifics but to summarise these concepts at a high-level, when a central bank wants to cool an overheating economy (which becomes evident when inflation increases beyond palatable levels) they will raise interest rates and essentially ‘pull the handbrake’ on borrowing in an economy. This leads to a broad slow-down in economic activity over time as companies and individuals borrow less (due to the increased cost of borrowing) and therefore undertake less new business ventures, expansion plans etc – all of which contributes to slower economic growth. This slow down often has cascading effects, companies borrow less, growth slows, companies’ lay off employees as their revenue reduces, which means consumers have less money to spend in the economy and so on. This usually affects your investment portfolio negatively as the future growth that you expected from your investment now looks less likely and therefore isn’t worth paying as much for in today’s terms. For a more detailed explanation on this it’s worth taking a deep dive into discount rates and how they are used to value investments by most professionals.

If you’ve been scratching your head wondering why interest rates are affecting the economy and your investments so significantly this year, then look no further you have the basic explanations right here.