Interest Rate Increases Cool Economy

By Richard McCaffery (TMF Gibson)
July 18, 2000

The Federal Reserve Board and Alan Greenspan have been hard at work trying to rein in a galloping economy this year.

The Federal Open Market Committee (FOMC), the committee that sets interest rates and credit policies for the Federal Reserve, raised interest rates six times in the last twelve months to keep inflation in check and keep the economy growing without overheating.

The Feds have said they'd like to see the economy, or gross domestic product (GDP), growing no faster than about 3.25% per year, a level many economists consider sustainable. GDP measures the total production and consumption of goods and services in the U.S. It's the broadest measure of economic activity and a main indicator of where the economy is headed. In the first quarter, the GDP grew 5.1% over year-ago levels, so it's really been smokin'. The Feds are working to cool things off.

See, growing the economy is kind of like cooking a marshmallow. You want it to grow evenly and gradually, which is why Fed Chairman Alan Greenspan uses the "steady hand" technique, not the "engulfed in flames" method. If it grows much faster than 3.25%, inflation takes hold, and that's bad for prices, for profits, and for business.

At the Fed's latest meeting on June 28, the FOMC opted to let the Federal Funds Rate stand at 6.5%. In a press release, the committee seemed cautiously optimistic that growth rates are moderating: "Although core measures of prices are rising slightly faster than a year ago, continuing rapid advances in productivity have been containing costs and holding down underlying price pressures."

The Federal Funds Rate represents the interest rate banks charge each other for overnight credit. Many industry observers spend a lot of time worrying about this statistic and the direction it's moving. You can, too. Or, you can do something more useful with your time, like hopping up and down on one leg.

Last June, the Federal Funds Rate stood at 4.75%. That 1.75% difference means it's more expensive for banks, companies, and consumers to borrow money. Less spending means slower growth.

Retail stocks have been hit hard by the increases. While the S&P 500 is down 1% year-to-date, consumer cyclicals -- a basket of stocks that includes everything from building materials to specialty retail stores -- are down a whopping 17.2%. That's a marked change from 1999 when the sector returned 15%, or its five-year average of 14.6%.

Not even wonder retailers like Wal-Mart (NYSE: WMT), which is having a fabulous year, escaped the shadow cast by higher interest rates. The company's shares are down almost 15% this year on fears that higher rates and a slower economy will discourage shoppers from spending freely.

What does all this have to do with long-term investing? Very little. Investors can't control interest rates, the velocity of money (how fast it changes hands), or ups and downs in the consumer price index. We can control what companies we invest in, however, and we aim to pick the strongest players and hold on for a long time. There are few vehicles that will protect your money against the hungry forces of inflation better than a good long-term equity investment.

At the same time, it doesn't pay to be ignorant of larger forces in the market. At Fool headquarters, we get piles of e-mail from readers wondering why the price of their favorite retail chain is falling. Lately, interest rates have been a big part of the mix.

The Federal Reserve also establishes the basic margin requirement for investors and traders. The Fed hasn't made any changes in the margin department of late, but that issue is getting heightened awareness as investors increasingly buy securities on margin and volatile markets have exposed some of the risks. Currently, the law says you can borrow up to 50% of the value of your marginable securities.

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