FOMC Meets Next Week: Fed May Taper Without Sending Interest Rates Sharply Higher

After months of anticipating that the Federal Open Market Committee (FOMC) will start tapering their purchases, we will finally get an answer when the Fed meets next week. Ever since the Fed Chairman, Ben Bernanke, hinted that the Fed might slow buying $40 billion a month in mortgage-backed securities (MBS) and Treasuries, long term interest rates have skyrocketed higher.

Long term bond rates and mortgage rates have already moved considerably higher the past four months, so rates might not move much higher even if the Fed does taper their purchases. That is, as long as the Fed doesn't shock the markets with a bigger move than expected by purchasing much less per month or even increasing the federal funds rate.

Mortgage Rates Move 130 Basis Points Higher the Past Four Months

Over the past 4 months, 10 year bond rates have increased from a low point of 1.62 percent in early May to Friday's close of 2.90 percent. 30 year conventional mortgage rates held averages as low as 3.27 percent in May are now averaging 4.57 percent. The federal funds rate which is currently set for a targeted range of zero percent to ¼ percent isn't expected to be increased.

While mortgage rates have increased, they are still low historically speaking. This is good news for those financing their home purchase or for homeowners who now have enough equity in their home to refinance due to the higher valuation of homes. Those who are looking for higher deposit rates will have to wait regardless of whether or not the Fed tapers.

How Interest Rates are Tied to The Federal Funds Rate

FOMC Meets Next Week Fed May Taper Without Sending Interest Rates Sharply HigherThe Fed doesn't set interest rates on mortgages but the Fed does have a direct influence on rates. The fed funds rate is the rate banks use to borrow money. When the rate is low, money is cheap and banks lower mortgage rates because their borrowing costs go down. When the rate is high, borrowing money is more expensive for banks so they increase mortgage rates.

Over the past five years, the Fed has provided an unprecedented amount of liquidity through various programs to drive interest rates lower. The Fed succeeded in driving mortgage rates and long term bond yields to record lows. These policies have also driven CD rates, savings rates, and money market rates to record lows.

Higher Deposit Rates Depend on a Higher Federal Funds Rates

Certificate of deposit rates and other deposit rates follow the fed funds rate in tandem. When the fed funds rate is lowered or increased, these rates follow. The current fed funds rate is just above zero percent and has been near zero percent since December 2008 when the Fed lowered the rate to combat the effects of the financial crisis and Great Recession.

A zero percent rate has sent average bank CD rates on 1 year certificates of deposit down to 0.06 percent in the FDIC's weekly rate survey. Thankfully, the best CD rates available are more than 15 times the FDIC average but still low historically speaking. The highest rates offered on 1 year certificates of deposit are just above 1.00 percent.

When Will The Fed Increase the Fed Funds Rate?

The Federal Reserve System, known as the Federal Reserve, was created 100 years ago in response to a series of financial panics, particularly a severe panic in 1907. One of the big complaints about the Fed has been the secretive nature in which they decide policy that affects the economy.

The Fed has become more transparent under Ben Bernanke and has actually stated for the first time ever when they plan to increase the fed funds rate. They didn't set an actual date for an increase but have said they plan to keep the rate near zero percent until the unemployment rate falls below 6.5 percent.

The current unemployment rate of 7.3 percent has been falling and is at the lowest point since the financial crisis hit. The rate has been falling about 0.1 percent a month, so the rate could conceivably hit 6.5 percent in the April 2014 report. At that point, the Fed will be poised to increase the fed funds rate.

The April non-farms payroll report will be released the first Friday in May 2014. The Fed meets the week before the report is released so it's possible that they would vote to increase the fed funds rate at that meeting. The increase will probably be 50 basis points, which would mean the deposit rate will increase by about 50 basis points.

Stay Invested in Shorter Term Certificates of Deposit

After years and years of record low deposit rates, higher rates will be welcome news. Since rates are moving higher and are likely to continue moving sharply higher in the coming years, stay invested in shorter term certificates of deposit or savings/money market accounts for now. That way you will be able to take advantage of higher rates when this up cycle starts.

Author: Brian McKay
September 15th, 2013