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Fed Fund Rate Isn’t it Ironic?

Isn’t it Ironic?

Alanis Morissette epic number might be the best song to hear when you decipher The Federal Reserve chair Jerome Powell’s recent announcement of FED’s intention to keep interest rates status quo until 2024. The Federal Reserve’s recent announcement that it will not raise federal funds rate until 2024, keeping the rate between 0 to 0.25% is at best perplexing. The following read on the Federal Reserve is not a critique on the Federal Reserve’s announcement but an attempt to understand the levers enabling the Fed Fund Rate.  The Federal Open Market Committee meets eight times a year to decide the rate.  “The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight.” FRED. The rates are set through a mechanism known as open market operation; a tool used by central banks around the world to fine tune liquidity within the system. More on it at a later date.

No doubt both the US and the world went through a colossal human and economic crisis but boosted by a ~$5 trillion fiscal stimulus, the US is back in the game. Based on FED’s prediction the growth is expected to be about 6.5% next year, a superlative achievement for an advanced country. The unemployment rate will fall to 4.5% by end of this year (median projection) and to 3.5% by 2023 is welcome news. The unemployment rate would be close to the natural rate by end of this year based on the Congressional Budget Office estimates the U.S. natural unemployment rate is about 4.4%. According to Jerome Powell “The median inflation projection of FOMC participants is 2.4 percent this year and declines to 2 percent next year before moving back up by the end of 2023”. As of March 2021, the US fiscal stimulus as a percent of GDP amounts to 26.64% of the GDP or ~$5 trillion, the highest in absolute terms and among the top 5 in G20 countries. Further, since 21 March 2019 FED has added ~$2.3 trillion of assets.

                    According to Taylor’s rule, the real federal rate is a function of inflation and GDP gap.
                                     Taylor’s Rule: Real Federal Funds Rate= 2 + 0.5 (Inflation -2)-0.5(GDP gap)  

Looking at Taylor’s rule the general impression is that the rates should go up earlier than expected. If the GDP rises above the natural level of GDP, the real GDP goes up. Okun’s law shares the relationship between the unemployment rate and rate of growth within an economy. A decrease in unemployment rate esp. below the natural rate would lead to an increase in GDP growth. The middle Road will do a deep dive to understand the view of the FED on interest rates. An excellent module to understand the Macroeconomics fluctuations within an economy. The interest rates in the US had already been at a low for an extended period of time resulting in the longest secular bull run in US history before the pandemic. Further, the FED will buy at least $120 B of Treasury ($80B) and asset-backed securities ($40b) purchases per month. since 21 March 2019 FED has added ~$2.3 trillion of assetsFed rates are a barometer for interest rates within an economy, serve as a reference for loans with low-interest rates boosting credit during recessions. However, an era of prolonged low rates enables structural inefficiencies within an economy through asset bubbles.

Jeeves says we are living in an era of the mother of all asset bubbles.

The increase in liquidity due to low-interest rates leads to artificial inflation of asset prices increasing systemic risk within the financial markets. In such times all asset classes might be performing better than their true intrinsic worth. For estimating intrinsic values of equity and debt assets, a method of calculating net present value of cash flows is used. Free cash flow model is one of the best methods of valuing equities. Refer to the read-on term structure of interest rates to get an overview of debt markets.

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