The Federal Reserve, or ‘the Fed’, sets the Federal Funds Rate through monetary policy. This is the rate that banks charge when they lend each other cash overnight. The Fed Funds Rate might seem like just another thing that only exists in the world of centralized banking, but it also serves as a baseline rate for several other types of rates that exist within our economy.
The Fed has become more transparent over the years about intentions regarding the Fed Funds Rate and Fed Chair Jerome Powell has mentioned on more than one occasion that the intention is to raise rates this year to help combat the nasty inflation we’ve been experiencing.
Raising rates should help inflation cool off a bit by making it more expensive for individuals and businesses to borrow money, the hope is that this will help slow demand and stabilize prices.
With the most recent rate increase of 0.75% there’s been some chatter about how this impacts those of us participating in the economy, i.e., all of us. But depending on what you’re consuming, how you’re saving, or what you’re spending money on, rate increases may impact you differently than your neighbor.
Deposits
The last few years savers have been starved for yield on their deposits. High yield accounts at one point were paying something like 0.50% and traditional savings accounts were paying about a tenth of that.
Over the last few weeks, we’ve seen rates on these types of products start to tick up a bit. Increasing rates may finally start to give savers a yield on their cash deposits.
Loans
While the low interest rate environment we have gotten so accustomed to has been pretty lousy for those sitting on cash, it’s been an ideal environment for borrowers.
Mortgages, especially, have been one of the stars during the last few years and while you could get a 30-year mortgage at around 3% earlier this year, we’re now seeing these loans above 5%.
Bonds
While the Fed Funds Rate can influence other types of rates, it does not control all rates within the economy. There are some types of bonds and other debt obligations that that don’t necessarily have a perfect correlation with the Fed Funds Rate.
The 10-Year Treasury is a good example of this. Looking back over the last 21+ years there is no absolute pattern when it comes to annual interest rate changes and the yield on the 10-Year Treasury.
Source: Dimensional Fund Advisors and The Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org
Despite no action by the Fed for almost seven years (2009 – Q3 2015) and then consistently raising rates over the next three (Q4 2015 – 2018), the Bloomberg US Aggregate Bond Index still had a positive return over the entire ten-year period.
Source: Dimensional Fund Advisors. Source: US Treasury data provided by FRED, Federal Reserve Bank of St. Louis. Bloomberg data provided by Bloomberg.
Stocks
Rate increases aren’t always bad news for stocks, either.
Below shows two periods over the last 21 years where the Fed has increased rates. During both of those periods, stocks fared pretty well.
The US Market ended the year positive each year when the Fed raised rates from 2004-2006. During the 2016-2018 rate increases, stocks ended the year positive in two of the three years.
Source: Dimensional Fund Advisors. US Treasury data provided by FRED, Federal Reserve Bank of St. Louis. Bloomberg data provided by Bloomberg.
With how transparent the Fed has become with their intentions, it’s possible that the news of additional rate increases this year is already priced into market returns.
We may have already seen the worst of it and there’s certainly a scenario where the stock market ends up positive for the year but there are also many scenarios where we continue to see stocks slip. Calling the bottom for stocks isn’t something anyone can do consistently, so we’ll just have to wait and see.
Bottom Line
Everyone hates inflation and there’s no disagreement there, but raising rates is the first line of defense we have to combat it.
As a borrower, you’ll have to pay more to borrow money, but the hope is that you’ll pay less for other things that also impact your personal bottom line.
As a saver, this could mean more yield on your cash savings, and that’s something we haven’t seen in quite a while.
As an investor, it’s possible that things turn around and we end up positive for the year in both stocks and bonds. It’s also possible that doesn’t play out, but rising rates don’t necessarily equal a death sentence for your portfolio.