pixel

Well, it happened again.  As expected, the Federal Reserve raised Interest rates another 3/4% or 75 basis points.  One of the main functions of the federal reserve is to conduct monetary policy, and through increasing interest rates it hopes to curtail inflation by slowing down economic demand.  But, what does it mean for you and your money?  Does it mean that all interest rates were immediately increased by three quarters of a percent?  Read on and listen to this episode of the Tom Dupree Show to see why, this time, the fed funds rate might not matter.

What Happens When the Fed Raises Interest Rates?

Fed Funds Rate

Fed Funds Rate

When the Federal Reserve announces a rate increase of 75 basis points, they are specifically increasing is the Fed Funds Rate that banks charge each other to borrow money from one another.  In other words, if member banks dip below their reserve requirement and need to borrow cash quickly from other banks to satisfy these requirements, they must pay more in interest to cover.  This makes them less likely to lend and should therefore make them require more interest from borrowers as a result.

 

Fed Funds Rate

Interest rate on reserve balances (IORB)

Simultaneous to this Fed Funds Rate Increase, the Federal Reserve also Increases the Interest rate of reserve balances (IOBR).  This is relatively new, and has arguably a much more powerful immediate impact on prevailing interest rates.  This is the rate of interest that the Federal Reserve pays on balances maintained by or on behalf of eligible institutions in master accounts at Federal Reserve Banks. The interest rate is set by the Board of Governors.  Rather than some banks utilizing the overnight funds rate, this rate hike immediately impacts the reserves of all banks.  Prior to this year’s first round of hikes, this rate stood at .15% as recently at March 16, 2022.  After this round of hikes, this risk-free rate stands at 2.4%.  This rate should filter throughout all interest rates, increase the cost of borrowing, and throw a little water on the inflationary fire ravaging the US.

 

Relationship Between Fed Funds Rate and Treasury Yield

The yield on US Treasuries should increase as the Fed Funds rate is increased, especially short term interest rates.  And there is an inverse relationship between yield and bond prices.  For bonds to yield more, the price of the underlying bond must decrease.

(For a method of calculating the direct impact of yields to bond prices click here)

10yr Treasury vs Fed Funds Rate Chart

Despite this most recent rate hike that saw the IORB rate jump from 1.65% to 2.40% on July 28, 2022, the yield on the 10 yr US Treasury has actually fallen from a high of 3.48% on Jun 14, 2022 to 2.61% on Aug 1, 2022.  This is evidence that increasing the Federal Funds Rate does not force interest rates to increase across all segments.

How Does Raising Interest Rates Affect Inflation

Inflation is at the heart of the Federal Reserves Interest rate hikes.  From an economic standpoint, increasing Interest rates is a demand side approach to combatting inflation.  Increasing interest rates causes a shift in the demand curve for money as follows:

  • The cost of borrowing money increases;
  • Therefore, the equilibrium quantity of money demanded will decrease;
  • Resulting in a lower money supply;
  • And therefore a decrease in the equilibrium nominal price for goods and services.