Money Rehab with Nicole Lapin - Which Interest Rates Do the Fed Control?

Episode Date: February 28, 2023

We know that the Fed sets interest rates... but it's not the interest rate you'll pay for a mortgage. To unpack what it really means, and what it means for you, Nicole calls up a friend of the show: Dr. Uncertainty (Dr. Richard Smith). Plus, Dr. Smith shares his predictions for where interest rates will land in 2023.

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money is working as hard as you do. So why overcomplicate your money? Keep it simple with Bank of America, your one-stop shop for everything you need today and the goals you're working toward tomorrow. To get started, visit bofa.com slash newprosmedia. That's b-o-f-a dot com slash n-e-w pros p-r-o-s media. bfa.com slash newprosmedia. I'm Nicole Lappin, the only financial expert you don't need a dictionary to understand. It's time for some money rehab. It's time for some money rehab. Last month we had Nouriel Roubini, a rock star economist known affectionately-ish as Dr. Doom. Today, we're talking to another economy nerd with a lofty nickname himself, Dr. Uncertainty,

or Dr. Smith. I asked Dr. Smith to give us a pulse check on the economy, what macro trends he's keeping an eye on, and what's worrying him or making him feel uncertain in the near term. And if you got through the doom, you will definitely get through the uncertainty and be better for it. Dr. Richard Smith, welcome back to Money Rehab. It's great to be here, Nicole. I've missed you. We had fun last time. You know what? I've missed you and I've not missed you because you scare me, but also have such great information.

Well, and rightfully so, right? I mean, look, I scared you last time and look what's happened since we last talked. Scary things have happened. So is it too soon for I told you so? Oh, no, I've been saying that for a while now. Okay, so since the last time we spoke, you warned about crypto. To be fair, I also warned about crypto. And I also don't think it's too soon to say I told you so. So what are the things you're most scared about? Is this the Halloween edition? Yeah. When people say that it's scary or wild times, there's always wild times in the economy, but this is a different variety. Yeah. Well, Milton Friedman famously said that monetary policy

has long and variable lags. In other words, you know, the Fed pushes buttons, pulls levers, but we don't know when those are going to actually have an effect. And so have you ever driven a boat? I have not. Like you turn the steering wheel and nothing happens, right? And then all of a sudden, you know, the thing jerks in the direction that you turn the steering wheel. And now you're headed like, you know, for another boat or you got to pull it back. But there's a delay before you can turn the other way and get it to respond. So that's just a very simple example of something with a long and variable lag. It's not that long, but there's a delay in the feedback that you get.

So the Fed has been extremely aggressive in their interest rate hikes, and nobody really knows if it's going to work or not, or if they're going to overshoot the mark. And so people having a sense of like confidence that this thing is under control is very misplaced. There's a lot of uncertainty ahead of us. There's a lot of volatility ahead of us because fundamentally nobody really knows what the heck is going on and what the heck 2023 is going to look like. Tell us more about rising interest rates. Where do you think they're going to go? There's actually, there was a 40-year uptrend in interest rates right before this 40-year downtrend in interest rates. It's a really beautiful symmetrical cycle. And so what's happening now isn't just a little blip on the radar. I think it's a sea change that is going to go on for decades.

So do I think we'll see interest rates at 20% again? I don't know. I hope not. But I really don't think we're anywhere near the peak in interest rates. And the fact is money has been free for years now, right? You can borrow money for nothing, literally. And some people even paid you to borrow their money. We're not in that situation anymore. Nobody really understands what a rising interest rate economy even looks like. We've had literally two generations or three generations that have only experienced declining interest rates. So that's one of the big C changes, systemic changes that I think is decades long.

And I think we're all still figuring out what the heck that means, right? When growth was rapid and borrowing costs were low, your growth was higher than your borrowing cost. And so you borrowed, borrowed, borrowed, borrowed, borrowed, right? And a whole lot of the economy is built on that. And that's gone now. So that's a big mental adjustment, big financial adjustment, individuals, businesses, everything, governments. So that by itself is a huge tectonic shift. Right. And only you would call the chart beautiful.

I'm imagining it. I'm sure it's quite beautiful because it looks probably symmetrical because history, especially in the economy, repeats itself. Mathematicians love symmetry. I know you do. If we had to look ahead and guess where interest rates would end, like where the terminal rate would be, what would you say? Well, which interest rates? Fed fund rates.

My guess is probably 6%. I think inflation is out of the bottle and the genie's out of the bottle. And I don't think it's going to be easy to put back in. And I don't think that the Fed has levers that make that easy to do. I think they're not as in control as they think. So Fed funds rate is not the rate that we would go and get at a bank. So let's be clear about that. Can you explain the difference between the Fed funds rate and then what we get when we go to the bank?

The Fed funds rate is what the banks loan money to each other overnight, right? So banks have to have a certain like balance between their assets and their liabilities. And so every night they go into the short term, you know, overnight lending market to either, you know, loan out or borrow assets. And this is the rate that they pay each other overnight. Meanwhile, we get nothing in our bank accounts right now, especially a checking account or even a savings account being way less than even 1% unless you go hunt for it. So I don't really get that, why the Fed funds rate has gone up so much, short-term interest rates have gone up so much, right? Whether you have treasury, two-year treasuries are like over 4%. So why the banks are still paying nothing

to their customers is a bit of a mystery to me. What is the typical lag with trickling down to consumers? Like where then, if you're saying 6%, where would mortgages then net out with a 6% Fed funds rate? Probably at 8% or 9%. You know, They were at 18%, 20%. Yeah, it's good to remind people of that. So in the early 80s, we were much higher than we are now, 20%. So if we're looking at this as investors or newbie investors, what is the way to profit from rising interest rates? It sounds like there's only one direction that they're going. We don't know exactly when that's going to end. But as an investor, as a retail investor, how can I profit from something like that?

Well, I mean, there's some good interest rates that you can get now, right? So you can actually buy some bonds and get some interest locked in over a long period of time. So buy two year bonds, you know, like you'll get paid 4% instead of earning nothing in your bank. But I think for most young investors who have a lifetime of investing ahead of them, the best thing to do is, you know, set up a strategy for dollar cost averaging your way into a long-term portfolio that ultimately is going to pay off decades in the future. You know, I don't think that technology is the place that everybody should be piling into anymore. I think that the kind of tech winter that we're experiencing is not going to

be short-lived. I know young people are attracted to technology, but I would caution everybody against just thinking that, oh, tech is so cheap now because it's not. And I think there are some real systemic things going on in the tech world that are going to take years to unwind. Well, some high quality investments might be on sale, so to speak. There's definitely opportunities out there. And blue chip long term companies, I think, are no harm in nibbling at them today. So there's two reasons why, you know, the tech sector could be down. One is because the entire market is down. And two is because they just have crappy fundamentals as a company. So you have to be really careful in assessing which of the tech companies are promising us is less valuable, right?

Because those are future dollars that the tech company is saying they're going to earn. When your dollars are in the future and inflation is eating into your future dollars and you can earn real dollars today, those future dollars are less valuable. So you don't get the growth multiples in the tech space that you did when, you know, interest rates were on a one way trip to negative. So that's really a big deal. If you are in a rising interest rate environment, then growth suffers, because growth is promising you dollars in the future, not dollars today. And those dollars in the future are worth a lot less

when they're getting eaten away by inflation. Yeah, I mean, when interest rates are low, it's like the go-go days. I think Buffett said when the tide goes down, you see who's swimming naked. Yeah, absolutely. Who forgot their trunks? So the tech sector is sexy, but bonds are better, even though they're not as exciting. You can have some of both. Bonds are really something that the public knows almost nothing about. That's something that we're missing out on. Money Rehab is a production of Money News Network. I'm your host, Nicole Lappin. Money Rehab's executive producer is Morgan Lavoie.

Our researcher is Emily Holmes. Do you need some money rehab? And let's be honest, we all do. So email us your money questions, moneyrehab at moneynewsnetwork.com to potentially have your questions answered on the show or even have a one-on-one intervention with me. And follow us on Instagram at Money News and TikTok at Money News Network for exclusive video content. And lastly, thank you. No, seriously, thank you. Thank you for listening and for investing in yourself, which is the most important investment you can make.