With the Federal Reserve keen to raise its benchmark interest rates this week, let’s review what the Fed Funds Rate is, why the Fed is taking this action, why it matters, and what investors should do in response to the Fed’s actions.
The full definition can be found here; think of it as the rate that banks earn by lending excess reserves to other banks. Here is the Fed Funds rate for the past 35 years, notice the upslope at the far-right of the chart that we are currently experiencing.
The Fed Funds rate essentially serves as the “floor” by which most other rates are determined. If a bank can lend to another institution in a risk-free manner and earn 2%, why would it lend to anyone else for less than 2%? This creates a cascade of rate increases for all borrowers - large/small/creditworthy or not.
The Fed has two jobs (referred to as its dual mandate):
When one of these two items deviates from target, the Fed will (or at least should) take action. Currently, the “price stability” mandate is... experiencing significant deviation from target.
So how do they fix it? The logic is quite simple:
That pesky fourth bullet point is the real doozy. As anyone who's been around kids has experienced, there is an amount of sugar kids can tolerate, and once you enter the “too much” phase… well… good luck.
The “too much” phase is where the economy was just a few months ago. As such, the ideal time to increase rates was likely 12-18 months ago, when prices were still stable, and the economy was growing.
The Fed is now playing catch-up and looking to navigate the economy off its sugar high without an ensuing meltdown. Much easier said than done, and commonly referred to as “engineering a soft landing.”
To start, there is a higher likelihood of missteps than the unrealistic expectation of perfection. The economy is a $100 trillion amalgamation of the activities of billions of people: messy, hard to predict, and constantly changing.
The Fed has already (somewhat) succeeded at slowing economic growth. Currently, there is no doubt that economic activity isn’t growing at the frantic pace as it was ~6 months ago, thus inflation should begin to slow in the very near future. Recent data suggests that business inflation expectations have peeked, and as such, the question is no longer one of “Will increasing rates slow economic growth?” but “Now that economic growth HAS slowed, how do we get a soft landing, and what should investors do in this environment?”
This question is always difficult to answer, especially given the current economic crosswinds. Let’s separate this decision by your investment horizon:
While I am monitoring the actions of the Federal Reserve, I am not making any changes to my long-term investment plan, especially considering the current drawdown. While predicting the bottom is impossible, it is very hard to bet against the data illustrated above.
Disclosure:
This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.
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