Recency Bias and the Fed’s Interest Rate Hikes

On every vacation we go on, my kids say something to the effect of, “This is the best vacation ever!” I typically follow up that statement with the question “What about that other vacation you said was the best?” And they respond, “Oh yeah! That was my favorite too!”

Is each vacation we take truly the “best” we’ve ever been on? Are we just upping the ante and topping each trip we take with a more exciting one? Nope. So then why do they think that each vacation we take is the best ever? Recency bias.

Recency bias is a cognitive predisposition that causes people to more prominently recall and emphasize recent events compared to those that occurred further in the past. My kids claim our current vacation is the best because it’s fresh in their minds, and they remember it most clearly.

When it comes to investing, recency bias shows up in many different ways: picking a stock or fund based on a recent surge in performance, overweighting a particular asset class due to recent outperformance compared to other sectors, assuming the current bear or bull market will continue, and generally losing sight of longer-term trends in things like gas prices, interest rates, and inflation.

Look no further than the current discussion of the federal funds rate. For reference, the current federal funds rate is 3.25%. A year ago it was .25%. 

So, if you look only at the recent history of interest rates, this may seem like a large jump. However, when you take a longer view and look at historical interest rate trends, we are still far below historical averages. Even news outlets use adjectives like “aggressive” and compare the current rate to the “most recent high in summer 2019.”

When you zoom out, looking beyond this recent time of uncharacteristically low interest rates, you’ll see that even with these increases, interest rates are still at historic lows. Over the past 60 years, the average federal funds rate has been just above 4.6%. From 1977-1991 the rate didn’t drop below that average and soared as high as 20.6% in 1981. We have had below-average interest rates since 2008. And even with the most recent increase, we’re still below historical averages.

Despite the historical data, the market reacted negatively over the last week to the news that the Fed is continuing to be more hawkish on inflation, with expectations of multiple interest rate increases in the next 12 months. 

Why this is somewhat of a surprise is confounding, as an important chart should be referenced:

Is the Fed “tight”? Hardly. Historically the Fed funds rate has been over inflation, and in some cases, for years. Unless supply chains heal quickly or we see a significant recession, in my opinion, we are a long way away from pausing rate hikes if we actually want to be serious about slowing inflation.

Low interest rates are fresh in people’s minds. It’s easy to focus just on that most recent data, especially when low rates have persisted for so long. When I remind my kids of a larger vacation we took a year ago (like Florida), suddenly the weekend we just spent up north is no longer “the best vacation ever.” It just takes a little reminder to put recent events into perspective. Hopefully, being reminded of longer-term trends, and adding more data points to the interest rate conversation, will widen people’s views and help eliminate some of that recency bias.

Note: The opinions expressed are the author’s views but may not reflect those held by other advisors at Walkner Condon Financial Advisors.