Twice in the past twenty years we experienced a cycle of decrease and increase in the Fed funds rate. And in both cases, institutions started increasing their rates slowly and gradually a few months before the Fed actually started increasing the funds rate. The most recent event occurred in anticipation of the Fed funds rate that took effect in July 2004. The second occurred prior to March of 1994, when the Fed funds rate started its climb back up. The question is: why would institutions raise their rates before the Fed?
The reason stems from the behavioral finance principle of anticipatory reaction. In other words, if I know that you know that I know, I will attempt to out-think you by going a step further than the one you think I will take in order to maintain my competitive advantage. Let’s look at an actual example from deposit pricing in an anticipation of a rise in the Fed funds rate.
In anticipation for a potential Fed funds rate increase in mid 2015, institutions want to stay competitive and protect their deposit balances. However, since institutions don’t know the price level their competitors will establish for each deposit product, once rates start rising, each institution is budgeting rates based on anticipated competitive moves. Moreover, in order not to have a price disadvantage, institutions attempt to outdo the competition by planning a greater increase than what they anticipate from competitors. The result: a pricing dynamic that raises rates even before the Fed has done so.
This behavioral finance game theory can be best illustrated in a simple and quick exercise. By participating in this exercise, you will experience first hand how everyone is attempting to out-guess the others and how the various responses differ from each other because they are based on what “they think that you think that they think."
So, here we go. Pick a whole number (no decimal point) between 1 and 100. The winner is the person whose number is closest to the average of all numbers submitted without going over the group’s average figure. Submit your number to this email (and do not post or share your response with others) no later than February 15. In a subsequent article, I will outline the outcome of this exercise and announce the winner.
Hint: everyone thinks that they know what you think and are very likely to try to outsmart you. Good luck!
Mr. Geller is an expert in behavioral finance and the author of the book Money Anxiety. He can be reached at email@example.com.