Investors and the media have been keenly focused on when the Federal Reserve will begin to raise interest rates. After each Federal Open Markets Committee meeting we focus on the slightest change in wording in the press release or during a press conference to see if we can deduce when rates will start to go up. Similarly, we evaluate the FOMC meeting minutes when they are released to see the specific thoughts and concerns of those making the decision.
But what are we so focused on? The Fed sets the “Federal Funds Rate,” which is the overnight rate for borrowed funds between depository institutions, and not what any of us pays for consumer loans. Since only those that are considered the most creditworthy receive this rate and because it is the shortest time frame for borrowing, it acts as a base for other interest rates throughout the U.S. economy. For example, the prime rate (the rate banks charge to their best customers) is often tied directly to the Fed Funds rate and will move in lockstep with it when changes are made. The prime rate then sets the base for various consumer loans and the level of interest paid on products like savings accounts.
Not all loans are based on the prime rate, though. Although products like home equity lines of credit are often directly based on a function the prime rate (ex. Prime – x percent), many primary mortgage rates are based on the yield of the 10-year treasury. Government debt (T-bills, notes and bonds) are initially sold through auctions, so prices (and yields) are determined by supply and demand.
Although the face amount and the interest rate are fixed, the yield will vary since they are being sold to the highest bidder and may be purchased above or below the face value. The amount an investor is willing to pay (and the subsequent yield they receive) for shorter term government debt is influenced, in part, by the Fed Funds rate. The impact of these free market, short-term rates can also affect that of longer dated debt. In theory, longer term loans require higher interest rates because your money is tied up for more time, increasing the chances of a default. This results in an upward sloping yield curve during normal economic times.
The Fed is trying to communicate with the public more than it has in the past. As mentioned above, through the press and by releasing FOMC meeting minutes, they are trying to be more transparent and reduce shocks to the economy. This can sometimes backfire as we have seen rates fluctuate based simply on comments from Fed governors at speaking engagements. In fact, I would argue that when the Fed Funds rate is increased is probably not as important as when the Fed strongly indicates it will raise rates, as that’s when we’re likely to see the changes in free market rates.
When a change in the Fed Funds rate occurs, there is a ripple effect throughout the economy impacting rates along the yield curve and subsequently demand for mortgages, credit cards, vehicle loans, corporate borrowing, etc. This is one of the many factors that affect the growth, or lack thereof, of U.S. Gross Domestic Product. The expectation of how higher or lower rates will impact corporate profits then plays into the price investors are willing to pay for stocks as well. It’s no wonder we follow so closely looking for clues as to what the FOMC will do next.
Todd P. Mazzo is an assistant vice president at Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.