How the Fed Funds Rate Impacts Earnings on Business Cash Reserves

A woman is calculating the return on her business cash reserves as interest rates are rising.

Businesses rely on their cash reserves to provide a buffer when operations are slow and to fund key projects that will help their business expand. Unfortunately, these cash reserves are often kept in accounts that are not especially productive. The rate of return that these accounts offer is affected by many factors, one of which is market interest rates.

In 2022, the Fed is expected to raise interest rates several times. This could result in an increase in the rate of return on business cash reserves, but the relationship between the Fed funds rate and yields on deposit accounts is more indirect than many believe.

Expectations for The Fed Funds Rate

With inflation at a multi-decade high, and the economy and labor market recovering, FOMC members and economists predict that interest rates will begin to climb in early 2022. Further, the FOMC said in its January statement that, “the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.”

By the end of 2022, FOMC members predict a Fed funds rate of 0.9%, and over the next several years, the Fed is expected to continue tightening monetary policy. According to FOMC members’ most recent economic projections, the Fed funds rate is expected to reach 1.6% by the end of 2023 and 2.1% by the end of 2024.

How the Fed Funds Rate Impacts Reserve Rates

When the Fed funds rate increases, market interest rates typically follow. This goes for debt instruments like bonds, and for bank savings instruments like deposit accounts and CDs. However, the rates that banks pay for deposits are not directly proportional to the Fed funds rate, and there are several reasons why this is the case.

Most importantly, banks need deposits in order to maintain liquidity. However, consumers have options for where to deposit their funds. They can choose between different banks or even choose to invest in a different type of security as an alternative. So, when choosing where to invest their funds, consumers typically consider the balance between the safety of their deposits and the potential return on their investment.

The safety of funds invested in accounts at FDIC member institutions is virtually identical, so banks that need deposits will often resort to enticing new customers with higher rates. On the other side of the equation, the rate of return that consumers demand in exchange for depositing their funds is often tied to the rate of return offered by alternatives with similar risk.

Short-term Treasury investments are common alternatives to deposit accounts. This is where the Fed funds rate starts to matter, as the rates for these securities typically follow the Fed funds rate. As rates on short-term Treasuries rise, their attractiveness as an alternative to deposit accounts increases. In order to compete with this more attractive alternative, banks will generally raise the rates they pay on deposits to retain customers and entice new depositors.

For this reason, deposit rates will often move in the same direction as the Fed funds rate, even though this correlation isn’t perfect. For example, in 2018, the Fed raised rates four times, bringing the Fed funds rate from 1.5% at the beginning of the year, to 2.5% by December, a 67% increase. In turn, savings account rates increased by 50%.

What Businesses Can Expect from their Cash Holdings

The Fed funds rate is only one of the factors that determine how much banks are willing to pay for deposits. Market forces within their community, and individual bank needs are also key drivers of the interest rates that banks pay on cash reserves.

Typically, banks increase the rates they pay for deposits when the bank needs more deposits and, currently, banks are flush with cash. Bank deposits at all U.S. commercial banks increased by more than $4.7 trillion from December 2019 to December 2021. In percentage terms, deposits have increased by about 36%.

This could mean that some banks aren’t in need of more deposits and therefore these banks could choose not to raise deposit rates as quickly as they have in the past following rate hikes by the FOMC. However, bank deposit needs vary by institution and region. So, deposit rates can vary as well.

Finding banks that need deposits can be a challenge. Fortunately, with advances in financial technology, commonly known as fintech, businesses can access the most competitive rates from banks that need deposits without geographical limitations. Our company, the American Deposit Management Co. [ADM], makes this process simple.

Get the Most Safety and Most Return on Business Cash Reserves

At ADM, we have developed a nationwide network of banks seeking deposits. These banks compete for business cash by offering businesses the most competitive interest rates available. Through an American Money Market Account [AMMA™], our customers have access to these competitive interest rates.

Additionally, with AMMA™, the entirety of a business’ cash reserves can be covered by FDIC insurance, the highest level of protection available. All of this occurs inside one account, with a consolidated monthly statement that makes reconciliations easy. To get started reaping the benefits of AMMA™, contact us today. Our online application only takes about 10 minutes to complete, and once you’re approved, our team of cash management specialists will be at your disposal.

At ADM, we keep our finger on the pulse of new developments in the banking industry. To stay abreast of these topics, visit our Insights page and follow us on LinkedIn, Facebook, and Twitter.