Week 22 Day 5: The Fed Funds Rate: The Rate That Rules Them All

The federal funds rate is the interest rate banks charge each other for overnight loans. The Federal Reserve adjusts this rate to control inflation and support employment. When inflation is high, the Fed raises rates to slow spending. When the economy weakens, the Fed cuts rates to encourage borrowing and investment.

The Fed's dual mandate: (1) maximum employment and (2) stable prices (targeting 2% inflation). Transmission mechanism: Fed raises the funds rate -> banks' borrowing costs increase -> banks raise rates on mortgages, auto loans, credit cards -> consumers borrow less, spend less -> economic activity slows -> inflation falls. The reverse happens when the Fed cuts rates. Recent history: 2008-2015: rates at 0-0.25% (financial crisis and recovery). 2015-2018: gradual increases to 2.50%. 2019-2020: cuts back to 0-0.25% (COVID). 2022-2023: fastest increase in 40 years, from 0.25% to 5.50%. Impact on your money: Savings accounts: rates rise/fall with the Fed. Your HYSA paying 5% in 2024 was paying 0.50% in 2021. Mortgage rates: loosely track the 10-year Treasury, which in turn responds to Fed policy expectations. Mortgage rates went from 2.7% in 2021 to 7.8% in 2023. Stock valuations: higher rates reduce the present value of future earnings, pressuring stock prices (especially growth stocks with distant cash flows). Bond prices: rise when rates fall, fall when rates rise (as covered earlier).

The Taylor Rule provides a framework for predicting Fed policy: r = r* + 0.5*(pi - pi*) + 0.5*(y - y*), where r* is the neutral real rate (estimated at approximately 0.5-1.0%), pi is current inflation, pi* is the target (2%), y is actual GDP growth, and y* is potential GDP growth. With core PCE inflation at approximately 2.8% and the output gap near zero in 2024, the Taylor Rule suggests a funds rate of approximately 4.3-5.0% -- close to the actual 5.25-5.50%. The long-term neutral rate (r*, also called r-star) is the most important and most uncertain input. Laubach and Williams (2003, updated regularly by the New York Fed) estimate r* at approximately 0.5-1.5%, but this estimate has wide confidence intervals. The implication: the long-term 'normal' federal funds rate is probably 2.5-3.5% (r* of 1% plus 2% inflation target plus a small buffer). The 5%+ rates of 2023-2024 are historically elevated but not unprecedented (the historical average since 1980 is approximately 4.5%). For asset allocation, the key question is how long rates remain elevated. The 'higher for longer' scenario benefits cash, short-term bonds, and value stocks while penalizing growth stocks, long-duration bonds, and leveraged real estate. The 'rapid rate cuts' scenario reverses all of these dynamics.