Twice in the past twenty years we experienced a cycle of decrease and increase in the Fed funds rate. In both cases, the Fed increased the funds rate by 25 basis points (bps) 12 months after the national average rate of deposits reached its turning point, or the point at which the national average rate ceased to decline and began turning upwards.
This turning point of deposit rates can be tracked by a variance analysis, which measures changes in the national average rate for deposits on a monthly basis. When the analysis shows a gradual decline in the rate variance, it means that the national average is nearing its turning point. When the variance reaches 0.00, no further decrease in the national average rate from the previous month to the current month has occurred, thus signaling a turning point.
Intuitively, people might think that interest rates on deposits follow increases in the Fed funds but the reverse is actually true: the Fed increases the funds rate after an initial increase in deposit rates. Why? Because the Fed constantly monitors multiple economic indicators, one of which is lending activities. When loan demand increases, it suggests an economic expansion related to housing, automobiles, business growth and hiring. Financial institutions respond by building up needed liquidity to fund these loans, which in turn creates higher demand for deposits and therefore higher deposit rates.
The first incident occurred in April 1993, when the national average rate hit the 0.00 mark (at 2.28% actual APY) while the Fed funds rate stood at 3.25%. Once the national average rate of deposits started increasing after the April turning point, it took the Fed exactly 12 months (March 1994) to boost the funds rate by 25 bps – from 3.25% to 3.50%. While the April 1993 rates look very high by today’s standards, this actually represented a very sharp decline in rates relative to the Fed funds rate of 8.0% experienced a few years earlier.
A very similar pattern occurred in August 2003, when the national average rate reached the 0.00 variance while at 1.38% actual APY and then started climbing. The Fed funds rate at that time stood at 1.25%; 12 months later, in July 2004, the central bank increased the funds rate by 25 bps, from 1.25% to 1.50%.
It appears that we are now nearing the turning point in deposit rates based on the variance analysis that I provide on a monthly basis. May or June may represent that turning point, which means that we may see a gradual increase in the national average rate for deposits in the second half of this year followed by a likely increase in the Fed funds rate by mid 2014.
Mr. Geller is the executive vice president of San Anselmo, Calif.-based Market Rates Insight, which provides competitive research and analytics to financial institutions. He can be reached at email@example.com.