Interest rates are typically market driven and in most cases, they are tied to the United States Treasury Bills and Notes. I say “typically” because the Federal Open Market Committee (FOMC) of the Federal Reserve also has a significant impact on interest rates.
The FOMC determines short-term rates by setting the Federal Funds (Fed Funds) rate. Today, the Fed Funds target rate is 0 to 0.25 percent; historically these are very low rates. The low Fed Funds rate is one of the main reasons the interest we earn on our checking and savings accounts today is minimal. The Fed Funds rate also helps set the Wall Street Journal Prime Rate. The largest banks in the country most often set the Prime Rate at 3 percent above the Fed Funds rate. Therefore, today it is at 3.25 percent. The Fed Funds rate and the Prime Rate have been at these levels since December 2008, when our economy was at the beginning of the recession. The FOMC will keep short-term rates lower in a below average economy in order to try to increase investment and help the economy recover. If the economy is improving and the FOMC thinks there is a risk of inflation, they will typically raise short-term rates.
When we see news reports ask the question, “Will the Fed raise rates soon?” they are discussing whether the FOMC will raise the Fed Funds target rate. Historically, the FOMC could not control longer-term rates like the 10-year U.S. Treasury Note rate. The market, based on the demand for U.S. Treasury Notes, normally establishes long-term rates. The market would weigh such factors as the health of the economy, risk of inflation, and value of the U.S. dollar compared to other currencies. Those elements still impact longer-term rates today. However, during the recession and up until 2014, the Federal Reserve actually bought a total of approximately $4 trillion in long-term bonds in order to help keep long-term rates, like home mortgage rates, low. The Federal Reserve still holds these bonds today. If they were to start selling the bonds, long-term rates would likely increase quickly. Since the FOMC does not want long-term rates to increase too rapidly, they are not in a hurry to sell them.
Due to the improving labor market, economists are anticipating the FOMC to start slowly increasing the Fed Funds target rate sometime between June and December of this year. However, a number of other economic reports seem to show the FOMC should wait to raise rates. Manufacturing output and homebuilder confidence have both recently fell for the third straight month. The strong U.S. dollar is already hurting exports of goods. Central banks around the world have cut interest rates this year and the European Central Bank started its own bond-buying program, all to help their struggling economies. If the U.S. decides to raise rates when others are cutting theirs, our dollar could get even stronger, which would negatively impact our global trade even further. The possibility that the FOMC will slightly raise short-term rates this year exists, but there is the chance that long-term rates could stay low due to the fact that the strong dollar might attract investors to long-term bonds.
After reading this, if it sounds as though no one is really sure what is going to happen with rates, that is an accurate assessment. It is this type of market confusion over the last few years that helped cause this headline on Bloomberg.com on March 16, 2015, “How Interest Rates Keep Making People on Wall Street Look Like Fools.”
Travis Jones is the Executive Vice President – Chief Financial Officer for GreenStone.
