On Wednesday 21 March, the Federal Open Market Committee (FOMC) of the Federal Reserve Bank (Fed) announced they would raise the interest rates by 0.25 % to a new target range between 1.5 % and 1.75 %. The FOMC argues that compared to its last meeting in January 2018, the economic activity and labor market in the United States has strengthened, whereas the core inflation figures over the past 12 months remains under 2 percent. Furthermore, the new chair of the FOMC Jerome Powell, said that interest rates could be raised more aggressively than currently expected, due to fact that monetary policy should not lag the real economic development.
What does the Federal Reserve do?
Fed is the central bank of the United States with headquarters in Washington D.C. It was initially founded in 1913 to gain central control over the monetary policy in the United States.
A central bank is the most important institution an economy has, as it sets the core interest rate for the whole economy. The Fed or any other central bank sets the rate at which other financial institutions, such as banks, can borrow money from the central bank. Banks may borrow money when they need liquidity, since they do not always have enough available, as their money is typically invested for the long term in things such as loans for businesses.
Since the central bank lends money to banks, it means it also has an immediate effect on the interest rates within the whole economic system. Therefore, it indirectly influences the interest rates for private people and businesses. The central bank uses the interest rate as a strategic instrument to steer economic activity and to attempt to control inflation.
Interest rates and the economic cycle
As an example, when the economy enters a recession, unemployment rises as companies have difficulty filling their order books. Consequently, they are forced to dismiss part of their work force.
The people who lost their jobs will then have further problems as they cannot rely on a steady income. This means their demand for products will decrease because they can afford less. This could lead other companies into financial problems, since the demand for their products decreases. Eventually, these companies are also forced to fire staff and thus the economy may enter a downward spiral.
To combat the economic cycle, the central bank could intervene by lowering the interest rates. By doing so, the central bank can stimulate the demand for money in the economy. This means that by lowering the interest rates, capital becomes cheaper and it therefore becomes more attractive for households and businesses to borrow money. This money will then be spent in the economy, which leads again to an increase in demand for products and services.
The recent Federal Reserve interest rate hike
The fact that the central bank hiked the rates, means that the economy is seen as being healthier. The unemployment rate is at 4.1 % which is a historic low in recent history, and unemployment is now even lower than before the economic crisis in 2008. It seems reasonable to assume the Fed is taking the right action.
However, the Fed is often criticised over holding interest rates too low, for too long. It is widely acknowledged that low interest rates stimulate the demand for money, which is exactly what central banks intend. On the other hand, if interest rates are held low over a long time-span, households take on more debt than they can afford.
For example, the former chairman of the Fed Alan Greenspan (1987 – 2006) is blamed for helping to fuel the financial crisis in 2008. Greenspan held rates at low levels, which could have amplified the housing crisis, as many took on debt to finance mortgage loans.
In the current situation economists fear again that the economy is “overheating”, because debt levels just hit record highs. For example, the open loans by commercial banks in the US more than doubled (+127% to now $2.5 trillion) since 2008. Now that the interest rates are being raised, this could become a serious problem. Banks will lose money on existing fixed-term loans, because they were issued at low interest rates and these loans could now yield more with higher interest rates. This leads to economic losses in the form of opportunity costs.
Consumers and businesses could also suffer if they have taken out variable-term loans, as they now must pay it back with higher interest rates, which could possibly lead to more defaults in the economy.
The effect on the economy
Equity and fixed income investors will also be impacted by higher interest rates, which could have severely negative consequences if the markets are not given enough time to digest the changing circumstances.
To understand how markets will respond, we need to understand how markets reacted to the low interest rate environment. It was said that low interest rates increase the demand for money and consequently the amount of money created in the economic system. With more money in the system, it must be invested somewhere. Most investors only invest in equities or fixed income products. When interest rates fall, newly issued fixed income products become increasingly unattractive as they yield relatively less. In contrast, the riskier equity products become more attractive as they promise higher returns. This causes the prices of equities to go up because the demand for stocks rises but the supply-side is limited.
If interest rates are rising, like they are now, the opposite effect can be expected. Investors adjust their portfolios, which can create high volatility in the markets and, in extreme cases, even panic.
This phenomenon can also happen in the fixed income market. The prices of traded fixed income products will fall when the yields go up, since the prices for traded fixed income products are inversely related to the yield curve. Imagine buying a corporate bond which yields 3% p.a. during a time that the yield on a simple bank account is only 1%. The central bank then suddenly hikes the interest rates to 4%, so the bank also adjusts the interest rate to the same level. Now, the 3% you get on your corporate bond seems like a bad deal as you could get more money at the bank, which is lower risk. This means investors would try to sell the corporate bonds; leading to lower demand, which would cause the prices of bonds to fall.
The examples given above become even more drastic when the dimension of the bond market is considered. Pension funds for example, are largely invested in bonds, as they must manage their funds conservatively to account equally for the interest of current pensioners and those making contributions. If interest rates rise too quickly, a lot of money from the pension fund could vanish. This would affect the pension fund’s ability to pay current and future pensioners, which can have serious social consequences.
All in all, it now seems inevitable that interest rates should be raised back to normal levels – but they have to consider the expectations and gradually inform the markets about the next steps, to avoid any nasty surprises.