2023 - 1st Quarter Market Update
What is the Federal Fund Rate?
With all the headlines regarding higher interest rates this last year, many may be asking, what exactly is the federal funds rate? The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight. When a depository institution has surplus balances in its reserve account, it lends to other banks in need of larger balances. The federal funds rate is the central interest rate in the U.S. financial market. It influences other interest rates such as the prime rate, which is the rate banks charge their customers with higher credit ratings. Additionally, the federal funds rate indirectly influences longer- term interest rates such as mortgages, loans, and savings, all of which are very important to consumer wealth and confidence. Source: https://fred.stlouisfed.org/series/FEDFUNDS#
Although 2022 was historic in its Fed rate hike cycle, the Fed funds rate is still below its 50-year average. From 1971 to 2023, the Fed funds rate averaged 5.42%, reaching an all-time high of 20% in March of 1980 and a record low of .25% in December of 2008. We have experienced a prolonged period of historically low interest rates since 2008. Financial markets and consumers are now adjusting to what may become a new cycle of short-term rates that are closer to, or higher than, the historic average. See chart below:
Volatility was a defining characteristic of the financial markets in 2022. Markets faced many headwinds which led to higher inflation, including higher interest rates, Russia’s war with Ukraine, and higher energy and commodity prices. The US and many other countries around the world faced higher inflation last year than they have experienced in recent decades. The Federal Reserve Board took historic action in 2022 to combat inflation by increasing short-term rates from 0% to 4.25% -- the greatest calendar year percentage increase in over 30 years. This was a major contributor to the financial market woes as businesses adjusted to higher borrowing and capital costs.
The Federal Reserve Board has indicated that they are near the end of their rate hike cycle, and the rate increase of 25 basis points this week was the lowest rate hike since they began their tightening cycle a year ago. Inflation is falling, and we are already seeing a slowdown in consumer spending habits. The easing of supply constraints combined with this easing in consumer demand has contributed to the lower inflation numbers in recent months.
What does this mean for investors?
One of the benefits for investors in a rising rate environment is that the earnings on short-term fixed income securities (CDs, money market accounts) also rise. To take advantage of higher short-term rates, we are in the process of switching the sweep (cash) holdings in many client accounts to a money market account. The holdings in this money market account are cash, government securities, and repurchase agreements for government securities. We feel this is in the best interest of our clients, as the cash holdings can now yield higher dividends than available in the current sweep (cash) account.