Interest Rate Increase

By Kevin Chambers

In mid-December, the Federal Reserve’s Federal Open Market Committee (FMOC) announced they planned to raise the target range on the Federal Funds Rate from zero to between 0.25% and 0.5%. In light of this news, let’s review a few of the issues surrounding this event.

Fed Funds Rate:

First off, what is it they are changing? The Federal Reserve sets requirements for banks to have a certain amount of cash in their vaults or in their account at the Federal Reserve. It is set at a proportion of the balance of the depositor’s asset value. For example, for most major banks the reserve requirement is currently set at 10%. Therefore, if the bank has $100 million in liabilities (depositor accounts), then they are required to have $10 million in reserve. Depending on their daily cash flows, deposits versus withdrawals, it is possible the bank could be short of their reserve requirement at the end of the day. To meet this requirement banks that are short of the requirement borrow from other banks that have excess of their requirement. The Federal Funds Rate is the interest rate for banks that lend to other banks overnight to meet this requirement.

The fed funds rate is the only interest rate over which the Fed has control. All other interest rates are determined by market forces. However, the fed funds rate is the base rate to which all other interest rates are related. As the fed funds rate rises, interest rates across the board are expected to increase also.

Why this matters:

At Headwater Investments, we have been eagerly awaiting for interest rates to rise for a couple of reasons. Higher interest rates reward savers over spenders. When interest rates are low, it is very easy to borrow money to buy houses, cars, and other products on credit. Whereas at the bank, savers have been getting almost no interest for the last 5 years. Although this first increase is very small and most depositors will not see a huge increase in their interest payments, it is a step in the right direction.

Higher interest rates also give the Fed a tool to use to combat future recessions. After the 2008 crisis, the Fed reduced interest rates very quickly from around 5% in 2007 to basically 0% by 2009. This generated spending in the economy, and this was one of the major contributing factors for the economic recovery. With interest rates stuck at very low values for many years, the Fed was working without one of their most effective tools in combating recessionary pressures. This led to new innovative monetary policy techniques such as Quantitative Easing. As interest rates rise, the Fed now has one of their tools back in their toolbox should the economy fall into another recession.

For our clients’ accounts, there should be a minimal negative effect in the short term, but a large positive effect in the long term. As interest rates rise, stocks and bonds have traditionally reacted negatively. For the stock market, most companies are considered “spenders” and have enjoyed having low interest rates to fund projects. Investors will probably be a little down on stocks for the short term; however, companies will be quick to adjust and moving forward there will be little effect. As interest rates rise, currently issued bonds will lose value as newly issued bonds will offer higher payments . However, once rates stabilize, higher yields will allow our portfolios to generate more income. (For basic information on how bonds work, see this post and how interest rates effect bonds, see this post.)

In summary, at Headwater Investments we are encouraged that the Federal Reserve has decided to raise interest rates, and hope that the trend continues.