Lesson 60 – When the Federal Reserve Moves Interest Rates

Topic Progress:

In our last lesson we looked at how The Fed enacts Monetary Policy by increasing and decreasing the money supply and what effect this has on interest rates. In today’s lesson we are going look at how The Fed will normally react at different points in the business cycle and what effect this is expected to have on the markets.

As you hopefully remember from our previous lessons, the economy goes through periods of growth and contraction which tend to repeat over time. These movements are referred to as the business cycle, a chart of which you can see here:

As we learned in our lesson on Fiscal Policy and the Business Cycle, the government tries to manage the business cycle with the goals of maximizing economic growth, employment, and price stability. As we learned in our last lesson the primary tool which the fed uses from a Monetary Policy standpoint to manage the Business Cycle is targeting the Fed Funds rate by increasing and decreasing the money supply.

Let’s now take a look at the Business Cycle and the balancing act that the fed must play in trying to keep economic growth at its full potential, while at the same time sticking to its goal of price stability.

Expansions: During an expansion employment is normally high and growing which means lots of people are getting paychecks to spend on goods and services and businesses are expanding to meet the growth in the economy. It is during this time that the balancing act The Fed must play between driving economic growth and keeping prices stable normally shifts towards the keeping prices stable side of the equation. In the early stages of an expansion the supply of goods and services can normally keep up with the demand, so prices remain in check. As the economy continues to heat up however situations can arise like we are seeing in the commodities markets as of this lesson, where demand is growing at a faster pace than supply, and therefore inflation begins to enter the picture.

It is for this reason that during the expansionary phase of the economic cycle you will normally see The Fed become concerned with keeping prices in check without slowing growth too much. The way that they will due this is by reducing the money supply in order to slow economic growth so that inflation does not get out of hand. As we learned in our last lesson, reductions in the money supply means increases in the Fed funds rate, and as we have learned in previous lessons, increases in interest rates means slower economic growth, which means a sell offs in the stock market all else being equal.

Peaks: During a peak employment is normally high but the growth in employment starts to slow and the growth in unemployment starts to rise. This means that growth in spending and therefore economic growth is leveling off and starting to turn downwards. As demand is moderating, this normally means that prices are also stable which allows The Fed to shift its attention back to keeping economic growth going and to avoiding a potential contraction.

With this in mind, during a potential peak in the business cycle you will normally see The Fed increase the money supply to try and bolster demand, which means decreases in the Fed Funds rate. As we have learned in previous lessons decreases in interest rates means higher economic growth, which means stock market rallies all else being equal.

Contractions: Although there are exceptions to this which we learned about in our lesson on fiscal policy, during a contraction price stability is not normally a concern and therefore the Fed’s full attention is placed on economic growth. This very simply means The Fed will become more aggressive in increasing the money supply, which means further reductions in the Fed funds rate, which means a pickup in economic growth and stock market rallies all else being equal.

Troughs: During a Trough interest rate cuts have started to filter through the economy and are working to push it back towards an expansionary period. During this time the balance will normally begin to shift back towards price stability and the posture of The Fed will normally be one of either inaction or a bias towards tightening the money supply causing interest rates to rise. The reaction of the markets in this case will generally depend on how quickly the Fed moves to raise interest rates and how quickly the economy is expected to emerge from the trough.

One last thing to note here is that there is a lag period between action by The Fed to increase or decrease the money supply and seeing the intended effects on the economy. As a general rule it takes 6 to 9 months to see changes in the money supply filter through and be reflected in the economy, so The Fed will often take Monetary Policy action in anticipation of future changes in the business cycle.

That concludes our lesson. In our next lesson we will look at how The Fed signals changes in Monetary Policy to the market before they are actually made, and how drastic market moves are expected to be under different circumstances.