​The Fed Raising Rates is Bad News for Your Retirement

Wesley Gray |

A lot of retirees love the prospect that the Federal Reserve may raise interest rates. With higher rates, there is less of an urge to reach out on the risk curve to achieve a desired nominal return bogie (we won’t discuss why this might be a good/bad idea, it simply is what it is). In this environment, a simple savings account should offer higher deposit interest rates. But do higher interest rates actually lead to higher returns on savings?

One of my academic buddies, Professor Alexi Savov, co-authored an interesting paper that answers this question. He finds that for every 1.00% increase in interest rates, the rate banks pay on a typical savings deposit rises by just 0.34%. So, even a 2.00% increase in rates would translate into a relatively paltry 0.68% bump in what consumers would receive from the bank. Not exactly a silver bullet for retirement planning

Let’s review the paper’s two main results in a bit more detail.

1. Increase in the Fed Funds Rate Leads to Higher Deposit Spreads

The figure below shows that when the federal funds rate increases, banks increase deposit rates as well, but less than one-for-one. Thus, deposit spreads widen. Especially for checking (green) and savings deposits (red), the deposit spreads are greater than 2.00% on average.

The Deposits Channel of Monetary Policy_1The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

2. Increase in the Fed Funds Rate Leads to Less Total Deposits

The chart below shows that changes in the federal funds rate are negatively related to the growth rate in savings deposits. In other words, when the Fed raises benchmark rates, depositors reduce their deposits. Interesting.

Here’s how the paper explains this weird phenomenon:

  • When rates are low, banks face face competition from cash. So they must charge low spreads to attract deposits.
  • However, when rates increase, cash becomes more expensive as an alternative, and thus banks have more market power. Banks are then able to charge their depositors more by keeping their deposit rates low. That’s why a Fed funds rate increase may facilitate deposit flows out of the banking system.

The Deposits Channel of Monetary PolicyThe results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Going Forward

The results highlighted above suggest a few potential paths for banks. Banks with a lot of retail deposits stand to make a lot more money after liftoff (Liftoff refers to the situation when the Fed raises interest rates to more normalized levels). So if you’re a stock-picker, look for banks with branches in noncompetitive places like some of the regional banks in the Midwest. Second, to maximize profits, banks are likely to contract their balance sheets, making credit tighter. Third, from a personal standpoint it might be a good time to think about moving your money to a money market fund or an internet bank to avoid becoming “a profit center” for a bank. Of course, as others do the same, you can expect Treasury bills and other safe liquid assets to become more expensive, impacting liquidity in financial markets more broadly.

Of course, this is all predicated on the idea that a “liftoff” will actually occur. Now that the world is seeing negative interest rates, there is a real possibility that Liftoff will never be seen…

The Fed Raising Rates is Bad News for Your Retirement was originally posted at Alpha Architect. Please read the Alpha Architect Disclosuresat your convenience.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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