The Federal Funds Rate is the interest rate at which banks and other depository institutions lend money to each other, usually on an overnight basis. It is an excellent benchmark for short-term interest rates and investors use it to determine how local government investment pool (LGIP) yields will behave. Unlike bank deposit products, stable net asset value LGIPs quickly adjust to upward movements in market interest rates.
Between March 2022 and March 2023, the Federal Reserve has increased the Fed Funds Rate at each of their 9 meetings, in 25 basis point increments, for a total of 19 increases. These increased have raised the Fed Funds Rate from the target range of 0.00% to 0.25% to the new target range of 4.75% to 5.00%. Elevated inflation, among other factors, have driven the interest rate hikes, which in turn has led to millions of dollars in interest earnings for NY school districts and municipalities over the last year.
LGIP participants are well-positioned to take advantage of rising rates once again. Given the short average maturity of pool investments, LGIP yields can adjust rapidly and provide a current market rate. As holdings in an LGIP mature, fund management invests these proceeds into high yielding securities thus providing investors with a more current (and higher) market rate. Many LGIPs have performed very well during this rising rate environment, closely mirroring the current Fed Funds Rate and, in many cases, offering daily yields incrementally higher than can be earned at local banking institutions. New York Cooperative Liquid Assets Securities System (NYCLASS) is a LGIP that has been serving NY municipalities and school districts since 1989 – www.newyorkclass.org/rates.
Despite another lower inflation reading in February 2023, the pace of moderation in prices continues to slow. Amid heightened market volatility and a still tight labor market, it has become increasingly difficult to forecast the Fed’s path from here. Given the recent developments in the banking landscape, the market has begun to price in the top of rates. The Fed opted to raise the Fed Funds Rate 25 basis points at the March 2023 meeting and signaled that the central bank was not necessarily finished with tightening policy. While acknowledging the uncertainty surrounding the recent developments in the banking sector, the Fed affirmed its commitment to supporting financial institutions further if necessary, but remained adamant that the system is sound and resilient. With inflation still running well in excess of the Fed’s longer-term objective, the possibility that rates remain elevated for longer remains very much in play.