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The Federal Reserve And The End of “Free Money”

The End of “Free Money” by Ben Strubel, Strubel Investment Management

It’s looking increasingly like the Federal Reserve will raise interest rates around June of this year.  Over the years it’s been popular for financial commentators, politicians, or really anyone to accuse the Fed of artificially inflating the economy and the stock market with “free money”.

Have you gotten any of the Feds free money? Nope? Don’t feel bad, I haven’t gotten any either. In fact no one has gotten any because there was never any free money to begin with.

Right now interest rates are zero (technically they are .25% but banks also pay a large portion of that to the FDIC insurance fund so it is just generally rounded down to zero). The zero percent interest rate means that banks receive or are charged an annualized percentage rate of zero for loaning money to each other or to and from the Fed overnight. This is why you get basically no interest in your savings account at the bank.

A zero percent Fed Funds rate means if you loaned money to the Fed each night for a year you’d get your money back and $0 in interest. The Fed Funds rate also has a strong correlation to the rate for one year T-bills. I don’t want to say it sets the rate for the one year T-bill because the Fed lets the bond market influence the rate but it doesn’t stray too far from the Fed Funds rate. For example as of this writing (2/6/15) the interest rate for the one year T-bill is .2%. (buy a T-bill for $1000 and one year later you get your original $1000 back plus interest payments totaling $2). No free money for you!

The free money thing is a myth, yelled loudly by people who don’t really understand how the banking system or the monetary system works.

Now, it is conceivable that low interest rates might spur people to borrow more money. But that hasn’t happened; a slowly growing economy has muted the demand for credit. The chart below shows the total credit market growth since 1949 in log scale. After the financial crisis credit growth has slowed markedly.

Free Money

Now what happens when the Federal Reserve raises rates? For illustrative purposes let’s assume they raise the Fed Funds rate to 1% (the actual raise is likely to be a quarter or a half of a percent). The rate for the one year T-bill will follow the Fed Funds rate up to 1%.

Now you can buy a one year T-bill for $1000 and after a year get your original $1000 back plus a total of $10 in interest payments. If the interest rate goes up to 5%, you would get $50 in interest. Now we are starting to talk about dollar amounts that mean something. When the Fed raises rates the increased interest payments are essentially the free money. Higher interest rates means that more money is being added to the economy.

Rising interest rates won’t be bad for the economy. Because most of the increased interest payments flow to financial institutions it may not be good for the non financial economy either. It’ll certainly be a boon for retirees looking for safe investments as newly issued CDs and bonds will likely have higher yields.

All in all, there is really nothing worth worrying about from the Fed raising rates. It won’t change much either way.

Dow Chemical Company

Just as an FYI we purchased Dow Chemical Company to occupy the spot in our dividend portfolio from Compuware’s going private transaction. We may write about Dow in a later newsletter.

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