How the Fed funds rates and inflation affect interest rates


Nov. 20 2020, Updated 4:38 p.m. ET

Factors affecting short-term and long-term interest rates

In the U.S., investors often look to the Federal Reserve’s (or the Fed’s) monetary policy outlook as an indicator of market interest rates. The Fed determines and communicates the appropriate Fed funds rate[1. Fed funds rate is the interest rate at which a depository institution lends funds that are maintained at the Federal Reserve to another depository institution overnight.] through its monetary policy decisions. The Fed funds rate determines the short-term interest rates in the market. Inflation expectations, on the other hand, drive long-term interest rates.

The Fed funds rate

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As the economy expands creating inflationary pressures, the Fed raises the Fed funds rate to control inflation. As rates go up, people tend to cut down on their consumption spending such as buying cars and houses on loan and prefer to save or invest more to earn higher interest. Decreasing demand for consumption spending helps bring down inflation.

Currently, the U.S. economy is seeing improvement, as indicated by several economic indicators. You can read about the leading economic indicators index pointing to economic strength here. As the economy improves, investors expect the Fed funds rate to rise and inflationary pressures to build up.

Changes in the Fed funds rate are also reflected in the performance of exchange-traded funds’ (or ETF’s) tracking Treasury securities such as the iShares Barclays 1-3 Year Treasury Bond Fund (SHY) and the iShares Barclays 20+ Year Treasury Bond Fund (TLT). However, since the interest rates have been low for a while and the market is expected to rise, investors sometimes prefer ETFs that are designed to play rising interest rates. These ETFs include the SPDR Barclays Investment Grade Floating Rate ETF (FLRN), which tracks the floating rate debt of companies such as Goldman Sachs Group, Inc. (GS) and JPMorgan Chase & Co. (JPM).

Impact on the Treasury yield curve

The Treasury yield curve is a graph that plots interest rates at different maturities. These maturities can range from a month to 30 years or more. Currently, the Treasury yield curve is quite steep, with short-term rates at an all-time low and long-term rates attracting investors who are thirsty for yield. So, when short-term rates rise, consequent to a rise in the Fed funds rate, the Treasury yield curve flattens, as the shorter end would rise more compared to the farther end.

The next part of this series talks about how a rise in interest rates affects returns from fixed income investments.


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