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Category » Interest Rates

Fed Funds Rate

July 19, 2016

Fed Funds Rate

The federal funds rate is the overnight rate that banks charge each other to borrow/lend  reserves.  Some banks have more reserves than they need.  Others (principally large banks) are short of reserves and must borrow from other banks in the system, typically on an overnight basis.  The rate at which this borrowing takes place is known as the fed funds rate.  It is the only rate that the Fed can directly control.  Most other short-term interest rates like Treasury bills, CD’s, commercial paper, etc. are very closely linked to this rate, so when the Fed tightens or eases all other short-term rates move in the same direction by essentially the same amount.

Once the recession began in December 2007 the Fed tried to stimulate the economy and ultimately pushed the funds rate almost to 0%.  It remained at that record low level until December 2015.

In December 2015 the Fed decided it was time to alter its policy and push the funds rate towards a more “neutral” policy stance.  So what might be regarded as a  “neutral” level for the funds rate?  The answer lies in the relationship between the funds rate and the inflation rate.  Whether an interest rate is high or low depends entirely on how it stacks up relative to the rate of inflation.  Think of it this way.  A 10% interest rate most of the time would be regarded as punishingly high.  But in the late 1970’s when the inflation rate was 12%, a 10% rate was actually quite cheap.  An investor could borrow at 10% for a year, buy an asset whose price would rise 12%, then pay back the 10% loan a year later and actually make money on the transaction.  So whether rates are high or low really depends upon their relationship to the rate of inflation.

The difference between the funds rate and the inflation rate is known as the “real” funds rate. Over the past 30 years, the funds rate has averaged 1.5% higher than the inflation rate.  As shown below, sometimes it will be higher than that, other times it will be lower.  But over time the “real” funds rate has averaged 1.5%.  Hence, the Fed would probably regard such a “real” funds rate as relatively “neutral”.  So if the Fed wants an inflation rate of 2%, and believes that its policy is neutral when the funds rate is 1.5% higher than that, then by implication is that a 3.5% funds rate in today’s world would be roughly “neutral”.

Fed Funds Rate -- Real

But the funds rate today is not at 3.5%, it is 0.25%.  Thus, the Fed has a long ways to go.  It typically would tighten by 1/4% every time it meets which is every six weeks.  At that pace it would take almost two years for the funds rate to climb from its current level of 0% to its neutral level of 3.5%.  This time, however, the Fed has indicated that intends to raise the funds rate at an even slower pace or, probably, about 1/4% every other time it meets which would be every 12 weeks.  If it tightens at this new super-slow pace it will take until mid-2019 for the funds rate to climb to the 3.5% mark.

Fed Funds Rate -- Projected

The U.S. economy has never dipped into recession until the Fed has pushed the funds rate higher than the so-called “neutral” rate.   If that is the case, it is hard to imagine how the next recession will occur prior to 2019.

Stephen Slifer

NumberNomics

Charleston, SC


Mortgage Rate

July 19, 2016

Interest Rates -- 30 Year Mortgage

Mortgage rates fell to a record low level of 3.4% by the end of 2012 as the Fed aggressively purchased both Treasury bonds and mortgage-backed securities.   The intent was to push long-term interest rates — mortgage rates in particular — lower and stimulate the housing market.  That appears to have worked in spades as the housing market rebounded sharply.

In mid-June of 2013 then Fed Chairman Bernanke spooked the market by suggesting that the Fed might slow its purchases of Treasury bonds and mortgages.    As a result, long-term interest rates — both bond yields and the 30-year mortgage rate — rose sharply.  In the case of mortgages, rates initially climbed from 3.5% to 4.5%.

What is interesting is that even though the Fed gradually reduced and  eventually eliminated its purchases of Treasury bonds and mortgages by the end of 2014, long rates are lower now that they were at the end of 2013.  The 30-year mortgage rate was 4.46% at the end  of 2013 when the Fed began to cut its bond purchases and stands at 3.5% currently.  Janet Yellen’s consistent comments that the Fed will raise the funds rate very slowly has been re-assuring to market participants.  In addition, strength in the U.S. economy versus weakness in Europe, China, and Japan has generated huge inflows of capital which have pushed rates lower.

Mortgage rates have declined about 0.4% since the end of last year in anticipation of a very slow pace of tightening by the Fed.  By the end of this year the 30-year mortgage rate is probably going to be slightly higher at about 3.6%.

Interest Rates -- 10-year versus mortgages projected

Stephen Slifer

NumberNomics

Charleston, SC


Treasury Notes — 10-Year Maturity

July 19, 2016

 

Interest Rates -- 10-year

The yield on the 10-year note backed up dramatically in June 2013 as fears mounted that the slower pace of Fed purchases of securities could translate into both higher long-term interest rates and slower GDP growth.  The yield on the 10-year rose from a low of 1.5% in June 2013 2.9% by December.  It then dropped back to 1.6% as the fear of aggressive Fed tightening has disappeared and inflation has remained low.

The question arises, what is an appropriate level for the 10-year note?   The answer to that question lies in something called the “yield curve” which is nothing more than the difference between long-term interest rate and short rates.  Today the 10-year note is 1.6%, the funds rate (an overnight rate) is 0.2%, so the difference between long rates and short rates, or the yield curve, is 1.4%.

Interest Rates -- 10-year versus mortgages

 

The steepness of the yield curve varies depends upon whether the Fed is tightening or easing.  When the Fed tightens it raises short-term rates (i.e., the funds rate) much more rapidly than long-term interest rates rise, the yield curve “flattens” and can even invert.  When it inverts it means that short rates are higher than long rates, and the spread is negative.  Frequently an inverted yield curve can be a sign that the Fed has raised rates high enough that a recession might not be too far down the road.  On the chart below the Fed tightening periods are the periods shown in white.  You can easily see how the curve flattens, and even inverts when the Fed is in tightening mode.  That is not the case today.

When the Fed eases they lower short rates (the funds rate) much more quickly than long-term interest rates decline and the yield curve “steepens”.  Periods when the Fed is easing are shown in pink in the chart above.  Once again the steepening of the curve when the Fed is in aggressive easing mode can be seen easily.

When the yield curve got to 3.5% the Fed was aggressively pushing the funds rate lower.  That is not the case today, and has not been the case for 6 years.  With the curve at 1.4% currently it is probably about where it should be for now.

Between now and yearend long rates may move slightly higher as the Fed continues its long-awaited  move towards a higher funds rate which will raise the level of the funds rate and boost the yield on the 10-year note as well (but by a far smaller amount). The yield on  the 10-year note will probably climb to about  1.9% by yearend.

Interest Rates -- 10-year versus mortgages projected

 

Stephen Slifer

NumberNomics

Charleston, SC