Predicting How an Increase in the Federal Funds Rate Will Affect You
We have heard a lot of chatter recently about the Federal Reserve’s timing on the increase of their federal funds target rate. The media and many investors have been anticipating this increase for a while now. However, in September 2015, the Federal Reserve agreed to leave the rate unchanged.
A common question we hear these days is “what should be done to protect ourselves when the Fed increases interest rates?” The media has convinced many in the general public that a fed rate increase will raise the interest rates on all fixed income, which will devalue the bond markets.
As college football analyst Lee Corso says every Saturday morning, “Not so fast!” The market reaction to a fed rate change is not so easily predictable. In many instances after the Federal Reserve has increased their target rates, there have been decreases in other interest rates or other results that were not widely predicted. A recent report from Dimensional Fund Advisors (DFA) gives us a better understanding of what can occur when the Federal Target Rate is raised. In the report, DFA gives specific examples of periods in history when the Fed adjusted their rate and the results of this change on interest rates.
Three examples from the report:
- 2013-2014 – “Bernanke, then chairman of the Fed, asserted that the Federal Open Market Committee (FOMC) was prepared to scale back its bond purchasing program. Market forecasters speculated that the scaling back of bond purchases would inevitably result in higher interest rates, but interest rates actually declined when the FOMC eliminated its purchases.” During this period of time, the news of this resulted in what was called “Taper Tantrum.”
- 2004-2006 – “The Fed increased the rate by 4.25%, yet longer-term rates experienced a period of decline. Alan Greenspan, Fed chairman at the time, referred to this phenomenon as a conundrum.”
- 1988-1989 – “The fed funds target rate was increased by more than 3% while longer-term rates remained largely unchanged. [1988-1989] was a period marked by an inverted yield curve; long-term rates yielded less than short-term rates.”
To summarize this information, if there are negative effects of rate changes, they do not seem to be immediate. The report emphasizes that history has shown that investors who have tried to forecast interest rates and the effects of an adjustment in rates have not been accurate. The federal funds target rate, along with short-term and long-term rates, are not always correlated and usually are influenced by other market factors as well. Thus, it would be difficult to say that an interest rate increase by the Fed would have an overall negative effect on markets.
Rather than concerning yourself with the Fed’s potential decision to increase rates, make sure your investment portfolio is created so that it is diversified in the most optimal way to weather the markets for the long term.