Federal Funds Rate Increase

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Federal Funds Rate Increase

Post by V1RTUS » Fri May 15, 2015 6:14 pm

I've seen an increasing number of economists predicting that the Fed is going to increase interest rates for the first time since 2008 in either June or September of this year. I have a basic understanding on how the change in interest rate affects the economy as a whole but curious as to what a rate increase would mean for us as individual consumers and investors? Thanks.
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Re: Federal Funds Rate Increase

Post by nisiprius » Fri May 15, 2015 6:41 pm

1) Vanguard published an amazing chart showing how utterly unable the market was to predict the Fed fund rate. The thin lines are what market rates predicted. The solid line is what actually happened. Not even close, not even in the short run. Wherever you see brushy "hair" sticking out from the thick line, the market was wrong.


2) What affects investors in the Vanguard Total Bond Market Index Fund and other typical "core" bond fund is the interest rates corresponding more or less to the duration of the fund, say 5-10 years. So what affects us is the 5, 7, 10-year Treasury rates. These are set by the market. The Fed's decisions and the Treasury's QE operations do influence it, but not all that much.

Go to Dynamic Yield Curve, drag your mouse back and forth across the right-hand chart to choose the year, and watch how the yield curve changes. Notice that the left end--the short-term rates, set or strongly influenced by the Fed rate, goes up and down a lot, but the effect out at 10 years is much less dramatic. It's a very loose coupling. Around 2007 you can even see the short-term rate go up while the intermediate-term rates go down.

3) People aren't very good at predicting intermediate-term rates, either. In April 2014, Bloomberg surveyed 67 economists. 67 of them--all of them, 100%, total unanimity--said the 10-year Treasury yield would rise over the next six months. Instead, it fell..

To summarize:
a) People can't predict what the Fed will decide to do about the fed funds rate.
b) What happens to the fed funds rate doesn't predict what will happen to the intermediate-term rates that matter to us.
c) People can't predict the intermediate-term rates, either.

The predictions of people reported by the financial media are extremely overconfident. They sound like they know what they are talking about. They do not. It is almost entirely noise. Tune out the noise.
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Re: Federal Funds Rate Increase

Post by Majormajor78 » Fri May 15, 2015 7:43 pm

That spaghetti hair expectation chart is quite possibly the best chart I've ever seen. Thanks! :sharebeer
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Re: Federal Funds Rate Increase

Post by lack_ey » Fri May 15, 2015 7:56 pm

In the long term, it means virtually nothing.

In the short term, it depends on how much the rate is increased compared to expectations. Far more relevant than the date of the first increase is the speed of the increases and where it ends up, so economic data and language about future actions may be more relevant than what actually changes in the Fed funds rate that day.

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Re: Federal Funds Rate Increase

Post by Rx 4 investing » Fri May 15, 2015 8:29 pm

The OP wrote: "I have a basic understanding on how the change in interest rate affects the economy as a whole but curious as to what a rate increase would mean for us as individual consumers and investors?"

The "yield curve" is a reliable predictor of US economic recessions and is Federal Reserve approved.

https://search.stlouisfed.org/search?&c ... ld%20curve

We can track the yield curve at home. An investor can monitor the "spread" between the three (3) month note and the ten (10) year T-Bond here (published daily). Hint: it moves very slowly. We can track it monthly.

http://www.treasury.gov/resource-center ... data=yield

A few definitions:

"Steep" or steepening: The "spread" between the 3 month note and the 10 year bond is very wide.

"Flat" or Flattening: The "spread" between the 3 month note and the 10 year bond narrows.

"Inversion" or inverting: The 3 month note has a higher yield than the 10 year bond.

Steep yield curve: implications for consumers?

Right now, we have a "steep" yield curve in the US. The Federal Reserve is trying to stimulate economic activity. This condition is associated with a very low probability of economic recession. Low interest rates stimulate borrowing, car notes, home loans, etc. The economy picks up and employers start to feel more confident and begin hiring employees.


Flattening or inverted yield: implications for economic activity and investors?

1) Banks borrow funds at short-term rates and lend at long-term rates. When banks issue fewer loans, economic activity begins to slow.

2) When short-term interest rates are higher than long-term rates (yield curve inversion) , investors have no incentive to buy long-term debt. As corporations issue long-term debt in the bond market, their funding starts to dry up.

3) The prime rate goes up with the increase in short-term rates. The profitability of companies go down as their interest expenses go up. Stock prices begin to fall on reducing earnings expectations.

In their paper on the yield curve as a predictor of recessions by the New York Fed, the table on page 2 shows that the probability of economic recession increases as the yield curve "spread" narrows. If you believe in the notion that the stock market looks ahead in anticipation of economic conditions, a risk-averse investor would consider periodically monitoring the yield curve, and begin reducing stock allocation as the "spread" continues to narrow.

For example, an investor who prefers tactical asset allocation (vs. buy and hold) might consider working out a systematic approach to arriving at Graham's or Bogle's stock minimums of 25% or 35% respectively, based on the recession probabilities found on page 2 of the paper.

http://www.newyorkfed.org/research/curr ... /ci2-7.pdf

Hope this lends some additional perspective.
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