Following seven years of near zero interest rates the Federal Open Market Committee (FOMC) on Wednesday announced that it would target a federal funds rate of 0.25% to 0.5%. A change of about 0.25% above where we’re at today. We should keep in mind that this new target rate is still ridiculously low by historical standards.
The Federal Funds Rate is the interest rate that banks and credit unions lend reserve balances to each other overnight. The rate is controlled through open market operations conducted by the Federal Reserve (the buying and selling of securities between the Federal Reserve and the open market). In taking action to increase this rate the committee is making money more expensive to borrow and communicating that they believe the economy is getting better. On a practical level we should expect to see a few things impact our daily lives. For starters the interest rate charged on all loans, including the interest paid on credit card balances and mortgages, will begin to rise.
Bonds, such as Treasuries, are a type of loan between the issuer and purchaser. Investors who are holding bonds and/or bond funds should see prices fall, and yields rise. This is simple bond mechanics at work and the nature of the inverse relationship between price and yield. The magnitude of these movements will be determined by bond markets. The last rate increase occurred between June 2004 and June 2006 where the Federal Funds rate rose approximately 4%. Performance of the Vanguard Treasury funds over this period provides a nice example of the price-yield relationship.
|Vanguard Treasury Fund Performance
(June 2004 – June 2006)
|Symbol||Fund||% Price Change||Yield Change|
What’s important to keep in mind is that all of this is out of the control of individual investors. We’re still early in the rising rate environment and we should probably expect to see additional small raises in the coming months. Precisely what happens in the future will be dependent on how the economy responds as the Federal Reserve is working to achieve its objectives of full employment and a 2% rate of inflation
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. 
As this process unfolds money will become more expensive for borrowers to the benefit of lenders. On the positive side those with savings accounts will begin to receive larger interest payments.
1. December 16, 2008 FOMC Statement
2. December 16, 2015 FOMC Statement
3. Federal Reserve Board Open Market Operations
4. What are the Federal Reserve’s objectives in conducting monetary policy?
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