The "Fed" and Interest Rates

If the Federal Reserve changes its mind a quarter of a percent, it can affect the whole economy. Why is the Fed so important?

If you watch any kind of national news broadcast or business program, sooner or later you’ll hear some talk about the “interest rate” and the Federal Reserve. Mysterious to many Americans, the Federal Reserve has an enormous impact on the economy.

How enormous? If you have a mortgage, a credit card, or just worry about prices rising where you shop, the Fed and its decisions directly affect you.

The Fed’s purpose. Basically, the Fed’s job is to keep the economy running smoothly. It watches economic data to see if the economy is growing too slow or too fast. When necessary, it responds by a) controlling the supply of money and b) adjusting the federal funds rate. This is the rate at which America’s major banks loan money to each other. Most short-term interest rates on loans and mortgages are priced relative to this rate.

When the Fed adjusts interest rates down. When economic growth seems to be slowing down and the risk of recession appears, the Fed often makes it easier for banks to borrow money by loosening credit and reducing short-term interest rates. The lower interest rates encourage people to spend more money, and this spending boosts demand for goods and services. As a result, big businesses borrow money to hire new employees, expand and increase production, and stock prices of these businesses often rise as well – all from one seemingly small mathematical decision.

When the Fed adjusts interest rates up. The economy can grow too fast and inflation can soar as a result. If the Fed senses this happening, it slows the rate of growth of the money supply. That prompts an increase in short-term interest rates and makes it more expensive to borrow. So it becomes more costly to make major purchases; fewer people buy houses, cars and other big-ticket items. As demand for these items decreases, companies produce fewer products and services and the economy slows down to a manageable pace at which inflation is controlled or reduced.

Who makes these decisions? Since February, Ben Bernanke has been the world’s most powerful banker – the Chairman of the Federal Reserve. A former Princeton University professor and presidential economic adviser, he replaced Alan Greenspan, who was Chairman for a remarkable 19 years (1987-2006). The heralded Greenspan adjusted interest rates to historic lows, which proved great for the real estate market and resulted in higher home values. He also supported the controversial idea to replace Social Security with private retirement accounts. Bernanke is considered more financially and politically moderate than Greenspan.

Why Fed-watching is such a spectator sport. Whole industries watch the Fed’s decisions, as well as foreign governments and corporations that depend on the pocketbooks of American consumers. Chairman Bernanke and other members of the Federal Reserve Open Market committee meet about every six weeks to go over economic data and consider raising or lowering interest rates. For the last two months, the Fed has left interest rates alone at 5.25%, after 17 consecutive quarter-percentage-point hikes. The Fed has seemed cautious about making moves in recent weeks, as the jury is still out on whether the economy is edging into recession or growing.

Only time will tell as it can take up to 18 months for the effect of each rate increase or decrease to be fully felt within the economy. Additional rate increases could be bad for stocks. Holding pat could be good for bonds. Rate decreases could be good for stocks and existing bondholders.

Please feel free to call me at 1-866-786-2521 if I can help you in any way.

The Pension Protection Act of 2006

How will the new pension plan laws affect you?

Last month, President Bush signed off on the Pension Protection Act of 2006, a set of rules and regulations intended to force companies to fully fund pension plans.

It requires America’s 30,000 traditional pension plans to be 100% funded by 2013. (Previously, 90% funding was acceptable.) But major airlines, even those like Northwest and Delta that have frozen pension plans, have until 2016 to fully fund their plans.

It also encourages automatic enrollment in 401(k) accounts and permits higher contribution limits to IRAs and 401(k)s in future years. The White House has touted the bill as a major curative for America’s pension woes.

However, the watchdog Pension Rights Center argues that the new laws will not stop companies from freezing pensions, and will result in a weaker pension system. Bradley Belt, former executive director of the Pension Benefit Guaranty Corporation, warns that "it will not insure against future loss of benefits under defined benefit plans. It will not in itself ensure financial security."

What do the new rules mean for you?

Deduction limits will rise for pension plans under certain circumstances. Rules for calculating lump-sum distributions from pension plans will change. Starting in 2008, you will be able to roll assets from a pension plan, 401(k), 403(b), or Keogh into a Roth IRA. If you pass away and designate someone other than your spouse as the beneficiary of your IRA, Roth IRA, pension plan, 401(k), 403(b), or Keogh plan savings, that person will be able to roll over those inherited assets to their own IRA. If you’re 62 or older, you can now ask about withdrawing pension plan funds prior to retirement in case of hardship.

The reforms also make it easier to contribute to IRAs and 401(k)s.

Recently increased contribution limits for IRAs and 401(k)s – set to be phased out after 2010 – are now permanent. It will be much easier to enroll in a retirement plan at work, and you will have greater access to investment advice and greater control over the money in the plan.

Please feel free to call me at 1-866-786-2521 if I can help you in any way.

What if There's a Recession?

Some economists think a recession is on the horizon. If a recession occurs, what should you do financially?

From Wall Street to the west coast, business and government leaders are paying attention to the possibility of a recession. Even if it doesn’t happen, it helps to understand what it would mean for you, your job and the people you care about.

What is a recession? A shrinking economy. Instead of growth, you have fewer jobs, and decreased production of goods and services. Unemployment rises, the stock market suffers, and real estate values dip.

Gross domestic product (GDP) is considered the best indicator of a recession. The GDP is the estimated total “market value” of the goods and services America produces. If the GDP goes down for five or six months in a row, you’ve got a recession. So what should you do if one hits?

Tip 1: Stay at your job. Recessions mean layoffs, and few new openings. If you don’t like your job, hang on – because if you leave it, you might have to tighten your belt for months.

Tip 2: Put away the credit card. A recession is not the time to buy a sports car or a toyhauler, start a small business, or take a weeklong vacation. If you are carrying big credit card or loan debts, it’s time to concentrate on paying them off. If you’re about to pay off your mortgage soon, make sure you do.

Tip 3: Don’t mess with your investments. In a recession, good investment principles still apply – though you might want to put more money into fixed-income investments, like bonds and bond funds and certain kinds of annuities. If you own stock in an automotive company or a company that makes luxury items, these companies usually hurt the most in a recession. Big-box retailers and other sellers or manufacturers of food or clothing tend to do well in a recession, and their stocks also usually do well.

The real goal is to hang onto your money until the market improves. There’s an old saying: “Cash is king in a recession.”

Recession ≠ depression. The two shouldn’t be confused. Most recessions end a year or so after they begin. In fact, recessions are really part of a cycle in the U.S. economy: roughly every six to 10 years, a phase of steady growth ends and a recession occurs. Tax cuts, increased spending and the actions of the Federal Reserve can nudge the economy out of a recession and back to health.

In the meantime, here’s hoping the “experts" are wrong and that the only thing we have to fear is fear itself. While the calendar says it’s about time for a recession – the last one occurred in 2001-2002 – it would be nice to hold it off a little longer.

Please feel free to call me at 1-866-786-2521 if I can help you in any way.