Increasing the Fed Funds rate or decreasing the Fed Funds rate has a sizeable impact on almost all corners of the investment world. The increases or decreases in the Fed Funds rate has particular importance for short term investments such as money market instruments, bank CDs and savings accounts.
When the Fed supplies more securities during open market operations it will be putting pressure on the Fed Funds Rate and ultimately lead to an increase in the Fed Funds Rate. The increase in the supply of short-term securities restricts the money in circulation since borrowers give money to the Fed. In turn, this decrease in the money supply increases the short-term interest rate because there is less money in circulation or credit available for borrowers. By increasing the supply of short-term securities and driving up the Fed Funds rate most all short-term rate based money market instruments will increase in lockstep. Bank CD rates, money market mutual fund yields and U.S Treasury bills will begin to rise.
Fed watching or interpreting the potential action of the FOMC is widely monitored activity. Market participants around the globe carefully scrutinize the wording of each Fed announcement, and the Fed governors’ speeches in a vigorous attempt to discern future intentions. Professionals and casual investors do fed watching as a way to guide investment decisions for greater returns. It is not enough to wait for an actual change in the fed funds rate; it behooves all investors to be prepared for the potential changes in direction. It can be extremely valuable for an investor in bank CDs or money market products to try to stay one step ahead of the fed funds rate, anticipating rather than observing its changes.
What happens to money and credit affects interest rates and the performance of the U.S. economy and to some extent, the world economy as well. The monetary policy the Fed develops refers to what the Federal Reserve does to influence the amount of money and credit in the U.S. economy. About every six weeks, the Fed meets to evaluate the condition of the U.S.economy. At these meetings, the Fed issues what is generally referred to as a risk statement. This statement measures the conditions of economic weakness or strength and the pressures that driving these forces on the economy.
Changes in monetary policy is performed by the careful buying and selling transactions set by the Federal Open Market Committee. These transactions, whether they are designed to ease or tighten monetary policy, takes place over time. The time it takes for the changes to take hold allows for an opportunity to reposition investment portfolios before the full impact of these changes take affect. Unfortunately, policy will change in short periods of time and there is no correct level of interest rates where the market will actually settle once the full impact of policy changes are absorbed in the market.
The risk assessment announcement by the Fed will generally include some commentary on the state of inflation. This may involve statements regarding the Feds concern about increasing inflation, which may lead to a future tighteming basis, or more concern for growth than inflation levels which would lead to a loosening basis. Either way, expected inflation levels are a key component of this risk assessment.
The Fed funds rate effectively sets the upper limit on the cost of reserves to banks, and thus determines the interest rates that banks must charge the public for loans. Bank interest rates influence the demand for loans, and thereby the net amount of bank lending. That in turn determines the liquidity of the private sector, which is important in terms of aggregate demand and inflationary pressures. The selection and control of the Fed funds rate is the key monetary policy instrument of the Fed. The Fed acts to influence the availability of money and credit by adjusting the level and/or price of bank reserves.
Movements in the fed funds rate have important implications for the loan and investment policies of all financial institutions, especially for commercial bank decisions concerning loans to businesses, individuals and foreign institutions. Financial managers compare the fed funds rate with yields on other investments before choosing the combinations of maturities of financial assets in which they will invest or the term over which they will borrow. Interest rates paid on other short-term financial securities—commercial paper and Treasury bills, for example—often move up or down roughly in parallel with the funds rate. Yields on long-term assets, corporate bonds and Treasury notes, for example, are determined in part by expectations for the fed funds rate in the future. Typically, Fed rate cuts and increases are passed down to investors and bank account holders in one form or another. Some accounts such as long term CDs will impacted more than others.
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