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how fed policy changes spending behavior

Updated: Feb 25, 2022

The federal reserve or the central bank is largely credited as the lead decision-maker for monetary policy in the United States. They help collect and manage our economic data.


I am simplifying, so I encourage you to continue researching beyond the information I provide because it is incomplete. There are links throughout the article that will be relevant in understanding more complex ideas that I have simplified into a sentence or two.


WARNING: Depending on the source you use, you will get drastically different interpretations of their work (the Fed is polarizing look no farther than the crypto community if you need an example).


As we learned in the integral approach, all interpretations hold some truth. However, it is remarkably easy to get lost in the conspiracy theory deep-end if you do not practice proper discernment.


The federal reserves main job is to "manage" inflation

The Fed is usually overwhelmed with the amount of data they have to process; they have determined two pieces of data to drive their decision-making process.


The first is Unemployed Americans that participate in the job market divided by the total number of eligible working Americans (the unemployment rate). Employment is strongly correlated to income, which is the backbone of our economy.


The second is to compare the price of goods this year to the cost of goods last year (also called inflation). If inflation rises quicker than the nation's total income, society's living standard has decreased.


Real growth is always the goal.


In America, we have achieved growth thru debt. Instead of making more things to sell, we borrow more to buy more. A by-product of growth thru debt is inflation (this is why we are in high inflationary times now).


The Fed has many tools, but their favorite is the funds rate


The Fed places most of its emphasis on maintaining a balance between inflation and deflation.


The Fed has four main tools at its disposal, but the one we refer to the most is the Effective Fed Funds Rate.


In your personal life, the Fed Funds Rate manifests itself as the interest rate you receive when you take out a loan. In addition to your credit score, this is also determined by economic factors.


The Fed Funds Rate controls the price of borrowing money across the economy.


The Fed can increase the rates which "constricts" the economy


When rates are increased, banks charge more in interest to take out a loan (even to worthy borrowers). This will increase everyone's monthly loan payment and decrease the amount of money we can afford to borrow.


The Fed recently announced it would like to raise rates in 2022. Simply mentioning the rate hike, mortgage rates approached a new 22 month high.


This will increase mortgage payments without increasing our buying power. This may lead to a correction in the housing market (reducing the price and inflation). See the chart below for a visible example, or play with a mortgage calculator to see it yourself.

Mortgage

A (2020)

B (2006)

Interest Rate (%)

3.1

6.41

Total Loan Amount

240,000

240,000

Loan Term

30 years

30 years

Monthly Payment

1,025

1,503

The increased monthly payment decreases the spending amount of money used on other goods. This will reduce the profitability of most businesses. If businesses make less money, they have to cut wages or cut employment opportunities. Overall this increases your likelihood of having bad financial luck.


Higher rates lead to more challenging times


Many people will have a hard time financially during these periods. Periods of higher rates are a breeding ground for corruption and economic instability.


It is impossible to say that you will go unaffected, but through proper financial education and prevention, you can help your odds.


Properly preparing and understanding decisions to make in an "expanded" economy can help you during a "constricted" economy. Many of these life events can be predicted and accounted for to increase the feeling of safety when life hits you fast.


The fed can also lower rates which "expands" the economy


When the economy needs more life, the Fed can lower rates. After the market crash of 2008, the Fed reduced rates and helped expedite the speed at which we recovered.


Decreasing the rate leads to increased spending power. Since someone's spending is someone else's income, this results in increased income and increased profits across the board.


Lowered interest rates cause assets to soar, generating wealth for those who own them


During the k-shaped covid recovery, many people realized how quickly asset prices could rise. Those that were in the position to capitalize managed to capture significant gains. Hedge fund manager Bill Ackman made 100-fold on his strategy to trade the pandemic.


The stock market, real estate market, and private market soar to new heights because cash is readily available. Lowered interest rates increase your financial luck because it is easier to find opportunities to make money.


The changes in rates typically are cyclical


Rates move in a 5-10 year cycle. Timing it perfectly is next to impossible, but understanding the larger cycle allows you to see when society's limited perception is influencing you.


Understanding the cycle helps you remain calm in the moment because you know everything will end up being okay. The goal is to borrow money during periods when interest rates are low to buy assets when the interest rate is high.


if you are aware of the cycle, you can make stronger financial decisions


In 2008 headlines pumped the general population with fear keeping many investors away from the stock market. If you could see past that news cycle, you would have been able to invest while the market was "on sale."


If you invested at the bottom of 2008 and held until Jan. 2022, your money would have increased 248% in value. To invest at the bottom is very difficult, but this illustrates how preparation and patience can help you in the long run.


Depending on where you were born on the cycle determines your view of the stock market


In addition to the short 5-10 year cycle, there is a larger 75-100 year cycle that follows the same pattern. Depending on where you are born on the longer cycle and your influences, will determine your financial belief structure (article coming soon). Your financial belief structure then manifests as your money persona.


If people do not address the persona aspect of the financial philosophy, it skews their perception of what works as financial advice. Dave Ramsey is a personal finance educator who believes debt is always wrong and advocates for investment in actively managed mutual funds.


This indicates that he does not acknowledge the existence of approaches that may work better for particular personas at a specific time frame. Which is a lot of words to say he is extremely biased in his thinking.


Beware of this bias when looking for information that would work in your particular situation. I will share some ways to think about a general contingency plan that I will share down the line. I hope you learned something interesting that you can take with you.


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