Fed Funds Rate – Explained

June 16, 2022

It’s not every day that a meeting of the US Federal Reserve Bank becomes a spectator sport. However, today (June 15, 2022), there was considerable buzz around this event. There was a countdown clock, endless commentary/predictions, and a televised press conference. Jay Powell (Chairman of the Federal Reserve) is now a well known celebrity (for better or worse). What does this all mean? Let me attempt to add some context

What is the Federal Funds Rate?

The Federal Funds Rate (FFR) is set by the Federal Open Market Committee, the policy making body of the US Federal Reserve Bank. It is the interest rate at which banks borrow and lend to one another overnight (banks are required to have a certain level of reserves at the end of each day and transact with one another to reach those levels).

Changes in this underlying rate has carry-on impacts to other interest rates that are tied to borrowing for consumers and businesses and as a result, changes in the FFR have far reaching impacts.

Broadly speaking, a rising/higher FFR tends to slow economic activity (as it becomes more costly to borrow for individuals and businesses). In contrast, a lower/falling FFR tends to encourage economic activity (as money is cheaper when interest is lower).

Why does this rate keep going up in 2022?

On June 15, 2022, the Fed Funds Rate was increased by 0.75% – the largest single increase in 28 years. The rate now sits at a range of 1.5-1.75%, which is still very low by historical standards, but has risen from 0-0.25% in the aftermath of COVID (Note: the FFR is set as a range, and the precise rate is based on the supply/demand for overnight borrowing between banks)

The FFR is one of the primary tools the Fed can use to stabilize the US economy. The Federal Reserve focuses on two broad aspects of the economy – inflation and unemployment – and uses the FFR (as well as open market purchases/sales of securities) to reach its mandates for those two items.

There is a need right now to slow economic activity – largely due to stubbornly high inflation levels (that’s a topic for another article – I’ll tackle that in a future writing) – so the Federal Reserve is increasing the FFR in hopes that borrowing and spending will slow, allowing inflation to subside.

Are they done increasing?

No. The Fed will continue to evaluate the data and determine if more hikes are required – but with what we know now – and with what the Fed has signaled, it is likely we will see more hikes in 2022, resulting in a FFR of 3.4 % by the end of the year.

What impact will this have on me?

There are two sides to an interest transaction – the lender and the borrower. Odds are you serve in both of those roles.

As an investor, the impact varies by asset class. Yields on cash and cash equivalents (such as bank accounts and money market funds) will steadily rise. As for the impact on other asset classes (such as fixed income and equities) this is far more nuanced and varied, so again, I’ll put this on the list for a future newsletter.

As a borrower, the impact of a change in FFR depends on the type of debt. Any variable interest rate debt (such as credit card debt, home equity loan, or a floating rate/adjustable rate loan) is likely to see an increase in the near term (typically takes one to two billing cycles). New installment loans (such as car loans) may also see higher costs of borrowing.

A rising FFR won’t impact any existing fixed rate debt – so if you took advantage of lower rates during COVID and refinanced (as we suggested to many clients!), you are set and will likely see a higher rate of interest on a money market than you’re paying on your mortgage in the not too distant future.

However, if you are seeking new debt currently (such as a mortgage), these rates are likely to increase as well. They don’t move in tandem with the FFR but do track treasury rates that are influenced by a variety of factors (including FFR, inflation, and forward expectations about economy).

Will higher rates trigger a recession?

This is the question of the day and the source of endless discussion on every financial news channel. Again, the Fed is trying to slow the economy down by rising rates (with the hope that such slow down also allows inflation to cool). There is of course a risk that they push the figurative breaks too hard, slowing growth to such a pace that we enter a recession (see more discussion of what a recession is here). It’s also important to note that the Fed is just one element of a very complex equation. Further COVID shutdown, supply chain status, midterm election forces, ongoing Ukraine/Russia conflict, impact of fiscal policy/Congress, and durability of consumers and businesses will all play a role in the path from here

What should I do now?

If you are an investor (and not a trader), you have a target allocation and aggregate financial plan in place. The playbook remains the same – stay invested over time in accordance with that allocation. Take advantage of the silver linings in a down market (read more here) and stay the course. This is a painful period – but rest assured that the Fed taking no actions would result in even more pain. These moves need to happen and ultimately, there will be a positive path forward

Where can I learn more?

Here is a link to an article published by Charles Schwab after yesterday’s meeting. It dives into quite a bit more detail on this topic. Hope you find it of interest

Note: All commentary above is as of the date of this post and is for education and informational purposes only. Windermere and its principals do not intend for this to serve as investment advice and are not responsible for any actions taken based on this article. Consult your financial advisor before taking any actions as it relates to your own investment portfolio

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