On Wednesday, September 26, the U.S. Federal Reserve announced a 0.25% increase in key interest rates for the nation. It will now be set at 2% to 2.25%, with further increases planned in 2019, which may impact the fixed-income F Fund since bond prices go down as interest rates go up. (The government securities G Fund is also impacted but to a lesser extent since by law principal invested in that fund is protected from loss although it carries the risk of too low of a return.)
This interest rate, known as the federal funds rate, is the rate at which depository institutions trade balances held at Federal Reserve Banks with each other overnight. It acts as a sort of baseline level for all other interest-producing securities and loans.
As the federal funds rate increases over time, it also increases mortgage rates, student loans, U.S. treasury rates, corporate bond rates, auto loans, and all other types of interest-bearing debt. This can affect corporate profitability and leverage, and also affects the desirability of bonds as an investment. Therefore, Fed rate hikes are among the most closely-watched items by investors and institutions.
This past week as reported by Freddie Mac, 30-year fixed mortgages reached a 7-year high at over 4.7%.
Here’s the key statement provided by the Fed: “Information received since the Federal Open Market Committee met in August indicates that the labor market has continued to strengthen and that economic activity has been rising at a strong rate. Job gains have been strong, on average, in recent months, and the unemployment rate has stayed low. Household spending and business fixed investment have grown strongly. On a 12-month basis, both overall inflation and inflation for items other than food and energy remain near 2 percent. Indicators of longer-term inflation expectations are little changed, on balance.”
– Federal Open Market Committee Statement, 9/26/2018
This is now the eighth 0.25% hike in interest rates since the Fed began raising rates in late 2015. They have averaged 2 or 3 rate increases per year. This chart shows the federal funds rate over the last five years:
The dual mandate of the Federal Reserve is to maximize employment and keep annual inflation rates near 2%. They raise interest rates as needed to keep inflation in check, and they reduce interest rates as needed to encourage business expansion to improve employment levels.
With official unemployment figures near record lows below 4%, and inflation rates near 2%, the Fed is gradually increasing interest rates over time.
The Fed provided projections for U.S. economic growth over the next few years, because these projections help provide a basis for their interest rate policy. According to the projections, the Fed predicts that real GDP growth will be 3.1% in 2018, 2.5% in 2019, 2.0% in 2020, and 1.8% in 2021.
Recent meeting minutes have shown that the Fed expects to increase interest rates by another 0.25% in December and perform three more 0.25% increases in 2019.
This gradual increase in rates has been the reason why the F Fund has had slightly negative returns this year. As interest rates rise, existing bond prices generally fall. The G Fund, however, is uniquely protected from losing value against rising interest rates, and has outperformed the F Fund over the past few years.
For example, in 2017 the federal funds rate was rising but the F Fund still had significantly positive 3.8% returns for that year, because longer-term rates weren’t really moved that year like they were in 2016 and 2018 despite continued raising of the federal funds rate. The F Fund is negative for 2018 so far, and has under-performed the G Fund since rates began rising in late 2015, although there are a number of factors other than the federal funds rate that affect F Fund yields and performance in any given year.