Let’s review what the Fed Funds Rate is, why the Fed is raising them, why it matters, and what investors should do in response to the Fed’s actions.
What is the Fed Funds Rate?
The full definition can be found here; think of it as the rate that banks earn by lending excess reserves to other banks. Here is the Fed Funds rate for the past 35 years, notice the upslope at the far-right of the chart that we are currently experiencing.
The Fed Funds rate essentially serves as the “floor” by which most other rates are determined. If a bank can lend to another institution in a risk-free manner and earn 2%, why would it lend to anyone else for less than 2%? This creates a cascade of rate increases for all borrowers – large/small/creditworthy or not.
Founders Note: At 32 years old I finally began to grasp this and how it impacts my savings, investing, and overall spending. We have been through some pretty positive times outside of the 2008 housing crisis (I was just going into college) and the financial impact of Covid-19 starting in 2020 (in the US) so understanding this in our age group wasn’t a necessity. I really wished I paid more attention to the macro and micro economic classes I had.
Why does the Fed want to increase borrowing costs?
The Fed has two jobs (referred to as its dual mandate):
- Maximum Employment
- Price Stability
When one of these two items deviates from target, the Fed will (or at least should) take action. Currently, the “price stability” mandate is… experiencing significant deviation from target.
So how do they fix it? The logic is quite simple:
- Raise rates to make borrowing costs more expensive and access to capital more difficult
- By making capital more difficult to obtain, consumers should buy a little less
- By buying less, demand for goods and services should decrease, and thus prices should stabilize
- BUT don’t raise rates so much that demand falls off a cliff, leading to a recession
Founders Note: Really clear ‘waterfall’ effect of what raising rates should do. It’s really this simple (of course some added variables can change this slightly).
Why does it matter?
That pesky fourth bullet point is the real doozy. As anyone who’s been around kids has experienced, there is an amount of sugar kids can tolerate, and once you enter the “too much” phase… well… good luck.
Founders Note: I might not have kids, but personally understand the effect of too much sugar in my bloodstream. It’s a pretty positive feeling for 20 minutes then just an aggressive slide into a sugar coma. As Frank continues to explain, we are currently in the ‘aggressive slide’ although The Fed would disagree.
The “too much” phase is where the economy was just a few months ago. As such, the ideal time to increase rates was likely 12-18 months ago, when prices were still stable, and the economy was growing.
The Fed is now playing catch-up and looking to navigate the economy off its sugar high without an ensuing meltdown. Much easier said than done, and commonly referred to as “engineering a soft landing.”
Will the Fed succeed?
To start, there is a higher likelihood of missteps than the unrealistic expectation of perfection. The economy is a $100 trillion amalgamation of the activities of billions of people: messy, hard to predict, and constantly changing.
The Fed has already (somewhat) succeeded at slowing economic growth. Currently, there is no doubt that economic activity isn’t growing at the frantic pace as it was ~6 months ago, thus inflation should begin to slow in the very near future. Recent data suggests that business inflation expectations have peeked, and as such, the question is no longer one of “Will increasing rates slow economic growth?” but “Now that economic growth HAS slowed, how do we get a soft landing, and what should investors do in this environment?”
What should investors do?
This question is always difficult to answer, especially given the current economic crosswinds. Let’s separate this decision by your investment horizon:
- < 1 Year: Consider Money Market Funds. Vanguard’s flagship money market fund is yielding 1.52%, while Schwab and Fidelity’s comparable funds currently yield 1.43% and 1.28% respectively. I expect most of these rates to be above 2% next week. Better than what you are earning in your bank accounts, with an effective guarantee that you will not lose your money/will have access on-demand.
Founders Note: This is where most recent retirees or soon-to-be retirees sit. They are about to need some money and don’t know where to put it. This also directly impacts people who need some cash or are trying to prepare for a large expense. I’d also add an HYSA like Ally or Yotta where you do in fact see greater than 2% in APY.
- 1-5 years: If you have funds that you truly won’t need for at least a year, consider an allocation to Ultra Short-Term Bond ETFs or I-Bonds (if you haven’t maxed out yet this year). Ultra Short-Term Bond ETFs earn a higher yield than money market funds, with the tradeoff being appreciation/depreciation following your purchase (whereas money market funds will retain their $1 per share value). VUSB (Vanguard’s Ultra Short-Term Bond ETF) is currently yielding 2.71%, while JPST (JP Morgan Ultra Short-Term Income ETF) is yielding 2.43%. As these are very short-term, you will have quite a bit of protection from rate increases and will benefit from those higher rates faster than intermediate or long-term bond fund investors. I-Bonds are inflation adjusted bonds issued by the US Treasury and available for purchase via TreasuryDirect.gov and are currently yielding 9.62%. That rate is guaranteed for the first 6 months of ownership, then adjusts based on inflation. A few important notes on I-Bonds:
- There is no liquidity in the first 12 months, so make sure you don’t need these funds for at least one year.
- If you redeem the bond in the first 5 years, you will pay a 1 quarter interest rate penalty (so that 9.62% will be closer to 7.2% if redeemed after 1 year and a day).
- You have to go through TreasuryDirect.gov (which isn’t the easiest website to navigate) to make purchases and are limited to $10k per person.
Founders Note: To make purchasing an I-Bond easier Yotta does have an I-Bond bucket yielding the 9.62%. Keep in mind there are other stipulations like not pulling your money out for at least a year and before 5 you see a 3 month interest penalty with Yotta. I also personally feel this is where you can purchase some well thought out stocks and allow the capital to appreciate as well as collect dividends.
- 5+ Years: While downturns in equity markets are never enjoyable, they create wonderful buying opportunities. The graphic below illustrates this by showing the returns for the S&P 500 following downturns of a similar magnitude to our current bear market over the past 100 years. Historically, the best time to buy is at the height of uncertainty.
Founders Note: This just echo’s my earlier note – dollar cost average into some good ETFs, Mutual Funds, and Individual Stocks. Putting some money behind my words I’ve averaged $5,700 placed in investments per month.
While I am monitoring the actions of the Federal Reserve, I am not making any changes to my long-term investment plan, especially considering the current drawdown. While predicting the bottom is impossible, it is very hard to bet against the data illustrated above.