Given the expectation for the Fed to continue to increase “rates” over the course of this year, we thought it would be helpful to provide some context on just what this means. The rate being described here is the federal funds rate, which is the benchmark or central interest rate in the U.S. financial market. This rate influences a myriad of other rates, including the prime rate, mortgage rates, rates on loans and savings, just to name a few, and is therefore vital to consumer wealth and confidence.
Now some background information. To begin, we start with the Federal Open Market Committee, or FOMC, which is the policymaking body or committee within the Federal Reserve System that makes key decisions about interest rates and the growth of the U.S. money supply. The Federal Reserve, or the Fed (U.S. Central Bank) was given the responsibility for setting monetary policy by the Federal Reserve Act of 1913 to serve as the country’s central bank. Monetary policy encompasses the measures employed by the government to influence economic activity, specifically by manipulating the supplies of money and credit and by altering the rates of interest.
As part of its monetary policy, the FOMC meets eight times during the course of a year to set the target federal funds rate. The federal funds rate, or fed funds rate, represents the interest rate that depository institutions (think banks, savings and loans, credit unions) charge each other for overnight loans. Please note that depository institutions are required by law to meet minimum reserve requirements equal to a certain percentage of their total deposits in an account at a regional Federal reserve bank – to cover withdrawals by depositors and other obligations. So, in respect of these reserve requirements, it may be necessary/desired to borrow/lend excess reserves from/to one another. The rate that the borrowing depository institution pays the lending depository institution is determined between the two and the weighted average of all these types of negotiations is called the effective federal funds rate. The effective funds rate is basically determined by the market but is influenced by the Fed via the above-mentioned target fed funds rate.
Please note that the federal funds rate differs from the discount rate (also referred to as the discount window), which is the interest rate that the Federal Reserve bank (i.e., one of the 12 regional Federal Reserve banks) charges on loans to commercial banks and other depository institutions. The discount rate is set by the Fed’s board of governors. Lending at the discount rate is part of the Fed’s function as the lender of last resort, and represents an important monetary policy tool. This lending by the Fed to depository institutions plays a significant role in supporting the liquidity and stability of the banking system and the effective application of monetary policy. Sometimes, banks borrow money from the Fed to avoid liquidity issues or cover funding shortfalls. The Fed funds rate is usually lower than the discount rate.
The current fed funds target rate is 1.50% to 1.75%, having been increased by 75bp (or 0.75%) at the most recent FOMC meeting that took place in June, which represented the largest rate move since 2000. The move was prompted by escalating inflation pressures (recent 40-year high inflation as measured by June 2022 CPI of 9.1% – highest since December 1981, driven largely by food, gas and energy costs). There remain four FOMC meetings in 2022 (July, September, November, December). The probability of another 75bp hike at the July 26-27 FOMC meeting is currently 98%.
The Federal Funds rate and the Prime Rate track along with each other very closely.
Short- and mid-term ARMs (adjustable-rate mortgages), such as the 5/1 ARM (fixed rate for the first five years then switching to an adjustable rate for the remainder of the term) shown in the graph above, are also affected by trends in short-term interest rates. As lenders’ cost of obtaining funds to lend changes, some of those reductions or increases are passed to borrowers in the form of lower (or higher) starting rates.
Long-term rates, such as 30-year fixed-rate mortgages, give less consideration to short-term rates, responding instead to economic growth and inflation pressures. Mortgages more closely follow other long-term rates, such as the yield of the ten-year Treasury Constant Maturity (theoretical value of a U.S. Treasury that is based on recent values of auctioned U.S. Treasuries).
All of these factors have weighed on the stock market. But the steps the Fed has taken have been necessary and should result in lower inflation and a stable dollar over time. This will not keep investors and the market from worrying over what the next few months will bring, but smart moves today will help support a healthy and growing economy in the future … a benefit for everyone.