Last week, the Fed increased the Federal Funds rate by 0.75% to 1.75%, the largest increase in the benchmark rate since 1994. The Fed fund rate is the interest rate at which banks lend reserve balances to other bans overnight on an uncollateralized basis. The general effect of increases in the lending rate is to make more expensive lending by banks to the general market. As the monetary theory goes, if lending becomes more expensive, the economy should slow, and the demand side of our current inflationary cycle should (eventually) break.
While the Fed rate doesn’t directly impact other interest rates consumers are impacted by, the correlation is clear.
As of Jan. 6, 2022, the 30-Year Fixed Rate Mortgage Average in the U.S. was 3.22%. On Thursday, June 16 that rate had increased to 5.78%.
Similar changes are experienced in the treasury market, with corporate bond issuances, car loans, and credit card payments. The Fed increasing the lending rate means lenders will expect higher interest returns for putting money at risk.
However, changes in one rate never occur lock-step with changes in others. So, while last Wednesday’s rate increase was significant in magnitude; it was nothing more than a step in what most economists expect to be a long-term path toward rate increases. The Fed’s median estimate released with the rate increase predicts a fed funds rate of 3.8% by the end of 2023, meaning we are not yet even halfway towards estimates.
As a result, as the Fed continues to tighten, it doesn’t mean that general lending rates or the yield curve will also continue to change. Those rates are predictors of the future, rather than reactions to the present.
Another caveat. The saying goes, that the Hall of Fame for predicting interest rates is an empty room. So, predictions about whether the rate will need to go to 3.8% or above 5% as it was prior to the Recession of 2008 is not time well spent, but changes in the consensus of the market will impact rates in the future.
The changing expectations will change the shape of the yield curve (and the value of bonds in circulation), and the rising cost of capital and related impact on demand will also impact equity valuations.
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