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By Glenn D. Vestrat, CVA, Business Valuation and Litigation Support Manager

Here’s what happened:

In December, the Federal Open Market Committee (the FOMC) of the Federal Reserve (the Fed) decided to raise the target range for the federal funds rate by ¼ of a percentage point, bringing it from ¼ percent to ½ percent. The federal funds rate is the interest rate that banks charge to lend reserves to each other in the federal funds market. When the Fed raises the federal funds target rate it also sells US government debt securities, thus reducing the money supply. As the nation’s central bank, the Fed has two important strategic objectives; promoting both maximum employment and a two percent inflation rate. By reducing the money supply, the Fed attempts to keep inflation in check.

After the Fed’s announcement, the prime rate inched up from 3.25 percent to 3.50 percent. The prime rate, reported by The Wall Street Journal, is the average interest rate charged by most large US banks to their most credit-worthy customers. An increase in the prime rate will probably translate into higher rates for consumer loans.

Since December 16th, however, yields on US Treasury securities did not rise, but instead, fell. The yield on the 3 month Treasury bill declined from 0.267 percent on December 16th to 0.226 percent on January 13th. Likewise, the yield on the 10 year Treasury fell from 2.30 percent on the 16th to just under 2.1 percent on January 13th. Market followers attribute declining yields in US Treasurys to investors buying Treasurys as a safe haven investment. When bond buyers bid up the price of bonds, yields decline to equalize the present value of the bond’s face amount and fixed interest payments.

What to look for in the future:

In Fed Chair Janet Yellen’s December 16th press release, she stated that the “. . . process of normalizing interest rates is likely to proceed gradually. . .” The term “normalization” suggests a slow increase in the level of interest rates above the current extraordinarily low rate environment. Gradual increases, and therefore higher borrowing costs for both consumers and businesses, should occur only if the Fed continues to meet its stated strategic objectives of maximum employment and two percent inflation.

What this may mean to clients:

An extended period of rising interest rates could usher in a period of improving returns to savers, but at the same time potentially slow future economic growth. The Fed’s strategy execution will be tempered by how the economy responds to rising interest rates.

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