What Does The Fed Raising Rates Actually Do? And Do They Want A Recession?

You may have heard that the Federal Reserve is in the process of raising interest rates and that its leading to a recession. Here's why that's exactly what they're trying to do.

They don't want to cause a full blown collapse of the economy, but I don't think they would mind a "baby recession" to correct valuations that reached all time highs. The stock market, home prices, and crypto

values had continually set and broken record highs over the last 14 years. A big reason for that is based on what the Fed did in 2008 in response to the great recession, lower the Fed Fund Rate from 5 1/4% to practically 0% (0.15%).

And why did they do that? Because people were freaking out that their 401k savings were cut in half with the stock market crashing by 55%, caused by mass default on mortgages when people bought homes they couldn't afford. (Movies like "the Big Short" detail how these subprime mortgages should never have been approved by predatory banks.) This creates a domino effect where businesses are forced to do layoffs, which leads to increase in credit card debt, and ultimately the worst thing possible, people stop spending.

Our economy can only function if people are buying and selling things. That's why everywhere worth looking has a sponsored advertisement. In 2008 national spending and the economy came to a crashing stop. The Fed did the one thing they could to restart the economy, cut the interest rate banks charge each other to 0%. And what the hell does that mean?

LATE NIGHT BANKING

Without getting into a full conversation on banking regulations, its important to know that every night banks are required to have a minimum amount of cash in reserves so people can take withdrawals. And why don't they have all our money in reserves? Banks make their money by lending our money out. Whether its mortgages, student loans, business loans, etc., the required reserve makes sure they don't lend all our money out.

But what happens if one day they give away too much of our money and drop below that reserve requirement? They do what we do in America, borrow it! And they borrow it from other banks for a night. I've always pictured this late night bank meeting in a dark alley with a bunch of old white dudes with wads of cash begging each other to get back to even. In reality they just send it electronically like a Venmo.

THE FED

And of course these old dudes don't just lend this money for free, they charge an interest rate on the late night loan. And since banks can't trust each other to set the rate, they rely on the Federal Reserve to set this "Fed Fund Rate". This rate is the most important thing in our economy. If banks are lending money to each other at 5 and 1/4%, you better believe the money they're lending via mortgages are going to have higher rates. So by cutting the Fed Fund Rate to 0%, like they did in 2008, banks can lower the rate they charge for loans, which creates an influx of cash into the economy and the spending machine can get back to cranking. And cranked it has over the last 14 years.

But here's the dilemma, what's the Fed supposed to do the next time there's a recession? Rates (theoretically) can't go lower than 0%. The Fed meets 8 times a year and decides what to do with rates. They started raising them in 2016, and then BAM Pandemic! Rates slashed to 0% again. The crank starts turning, but then it turned too fast!

Lower rates affects our Savings accounts, banks pay us less interest when rates, which makes people look for other ways to get returns, mostly the stock market. On top of that, the government decided to make it rain money. Trump and then Biden approved stimulus checks, which created a lot more disposable income that went into the stock market, housing market, and crypto, and helped to boost the economy during a scary time.

But then those last rounds of Biden Bucks were issued. Stocks, homes and (some) crypto are limited supply assets. That influx of money when the economy had already seemingly rebounded, caused all prices to go even higher and put the economy firmly in bubble territory, ready to POP! Mixing all this with global supply chain issues caused the prices of normal goods like baby formula, gas and toilet paper to go up too, known as inflation.

WHAT IS INFLATION

Inflation is normal. Its simply the concept things get more expensive every year (except $1 Arizona Ice Tea and $1.50 Costco Hot Dogs). Growing up I lived on 50 cent sodas, now a can of Coke is $1.25... inflation! The normal annual inflation rate is 2%, but in March we peaked at 8.5%! Those numbers have not been seen in 40 years.

There was simply too much demand for goods and not enough supply. Enter the Fed! I already said that the the Fed can't keeps rates at 0%, theoretically, 1 crazy person in Russia could start a World War and collapse the global economy. So rates have to go up to give us some defense in another crisis (please no more).

But also, and more importantly, one way to fight inflation is by increasing rates. If the Fed makes the banks pay more interest, then banks will force customers to pay more interest, which lowers people's spending power and slows the crank. So that's exactly what the Fed did at the beginning of May 2022, raised rates by 0.5% (known as 50 basis points. 1% is 100 basis points), which has raised rates for all loans. When I talk about people's spending power, if could pay $1200/month for a mortgage, in April 2022 you could afford a $350,000 home, and now can only afford a $240,000 home with the extra mortgage interest.

The Fed was expected to raise rates by 50 basis points for the foreseeable future in an effort to aggressively fight inflation, but this drop in the stock market and in consumer confidence in the economy, had them lower that to 25 basis points for the next rate hike. Not a great sign. We're in a situation where were fighting economic wars on two sides: inflation and market downturn. The stock market, housing market and crypto have all been decimated over the last month, credit card debt is increasing, companies are having trouble raising money and are being forced to do layoffs.

GOING FORWARD

My assumption is we see an uptick in the unemployment rate, which will make it harder to get a job, flipping the power back from employee to employer. For the housing market, we've reached a peak in home prices. The 30 year fixed mortgage went from a low of 2.75% to current 5.1%, that's a huge difference in monthly price and people won't be able to afford current valuations which will force sellers to lower listing prices. For crypto, its a cold winter as everything is down big across the board. Bitcoin for example is down over 50% from its high last year.

Finally the stock market is down 15.5% from its peak, led by a selloff in the tech sector. This a great time to look for discounted stocks if you have the appetite. We've already seen some uptick in the stock market, so maybe we've reached the bottom, but the worst thing anyone can do is sell at a bottom, even as scary as it is to hold and ride it out. Markets historically have rebounded 4-5 years after a recession, so as long as you have the time, its worth holding, if not investing more. If you're understandably scared, its important to remember "THE STOCK MARKET IS NOT THE ECONOMY". Its only one component of it, along with things like GDP, unemployment, CPI.. but those are topics for other days.