Fed Raises Interest Rates: What Does It Mean To Us?

On any particular day, some banks have a surplus of reserves, others have a deficit. A market arises for banks to lend excess reserves to banks with a deficit of reserves…

By, Brian Barker

Federal Reserve officials came and went this past week. Before they went, they raised the target range on the federal funds rate to 1.75%-to-2.00%. The range was lifted 25 basis points (a quarter of a percentage point) above the previous range.

The increase was really a non-event. Most market watchers expected the Fed to raise the range. The Fed followed the script and raised the range for the second time (in 25-basis-point increments) this year.

Another increase is all but assured. The odds are rising that two more increases could occur before the end of the year.

The federal funds rate is an overnight lending rate for commercial banks. It’s a base rate and an important interest rate. The federal funds market, to which the federal funds rate applies, works this way.

Commercial banks maintain reserves with the Federal Reserve. Commercial banks maintain reserves to meet reserve requirements set by the Fed. The reserves serve as a base for generating loans. They also serve as a means to clear financial transactions. When checks written against a bank are presented, the bank must have the money to honor the checks.

On any particular day, some banks have a surplus of reserves, others have a deficit. A market arises for banks to lend excess reserves to banks with a deficit of reserves.

Short-term lending rates respond immediately to changes in the federal funds rate. Long-term rates respond with a lag, if they respond at all. The Fed can raise the federal funds rate and short-term interest rates can rise above long-term interest rates if long-term interest rates don’t respond. In this case, the yield curve inverts, which can signal a recession.

Long-term interest rates will respond if the Fed raises the federal funds rate to hold consumer-price inflation in check. Consumer-price inflation is a key variable in long-term interest rates.

The Fed increased its inflation outlook last week. It projects consumer-price inflation to run at 2.1% annually for 2019 and 2020. Consumer-price inflation runs hotter than 2.1% now.

The May reading of the Consumer Price Index shows inflation running at a 2.8% annualized rate. It hasn’t run this hot in six years. The good news is that the credit- market response has remained muted. The yield on the 10-year U.S. Treasury note moved a couple basis points higher.

We saw a slight increase in mortgage rates this past week. Quotes at the national level on a prime 30-year conventional loan remain ensconced between 4.625% and 4.75%. Quotes have crept closer to the 4.75% boundary.

Is this as good as it gets going forward?

All signs point to a rising-interest-rate environment. Reprieves are always possible. That said, to float on the prospect of a reprieve is more of a gamble and less of an analytical decision.

Did Warren Buffett Call a Market Top in Housing?

USG Corp., the largest maker of drywall, recently announced that it will be acquired by Germany-based Knauf for $7 billion. The acquisition was given the green light by Berkshire Hathaway, which owns 28% of USG’s outstanding shares.

Berkshire Hathaway has served as Warren Buffett’s investment vehicle for the past 50 years. Warren Buffett is the most acclaimed investor in the past 50 years. Buffett buys when others are selling. He sells when others are buying. No investor has employed the strategy to greater wealth-generating success.

Buffett scooped up his USG ownership position during the financial crisis 10 years ago in a deal that valued USG at less than $1 billion. When the Knauf acquisition closes, Buffett’s USG investment will net him around $2 billion, nearly seven times his original investment.

USG has prospered with the new-home market. Drywall is an obvious input to a new home. Buffet has the knack for buying low and selling high. More than a few commentators have connected the dots. They have publicly speculated if Buffett is selling USG near a market top in housing.

We’re more sanguine on Buffett’s sale. USG has performed only “okay” since the housing recovery. It reported $2.9 billion in annual sales in 2011. It reported $3.2 billion last year. That’s only 1.7% annualized growth. Buffett simply received an offer too good to refuse on what is really a middling business.

Berkshire Hathaway still owns $23 billion worth of Wells Fargo stock. Wells Fargo is the largest mortgage originator in the country. No Wells Fargo shares have been sold.

In other words, it’s still all good with housing.

Brian Barker,
BBVA Compass
A Corridor News Contributor