What happens when the fed increases or decreases interest rates?

On 27 July 2022 (EDT 2:30 PM), the US Federal Reserve announced a 0.75% increase in interest rates. Following the announcement, ASX opened higher, and most sectors are trading up.

Post the Fed rate announcement, the rising interest rate has been among the most discussed topics. In this article, first, we will try to understand how other countries are impacted due to the increase in interest rates. We will also observe its impact on the Australian market post the interest rate increase announcement.

Impact of rise in US Fed rate:

To understand the impact of the US Fed rate, let us initially try to understand “What is the Federal fund rate?”. 

 The federal interest rate is the rate at which the commercial banks borrow and lend excess reserves to each other overnight. This rate is fixed by the Federal Open Market Committee (FOMC). Based on economic conditions, this committee sets the interest rate, which is set eight times during the year. The rate fixed by the committee has a direct impact on consumer loans and credit cards.

Other than this, investors keep a watch on this rate as it impacts the global stock market. Now the question arises how does it impact the other countries around the world? The answer is quite simple. The US is the largest economy in the world, and even if it makes a small movement, it has a direct impact on the rest of the world.

The US dollar is considered the benchmark for existing and upcoming economic growth in many parts of the world. In developed nations, a strong dollar indicates a positive sign, while the situation may vary when it comes to developing economies.

When the US increases the borrowing rate, it becomes more costly to take a mortgage or a car loan, or a business loan. People and businesses are less likely to take a loan. Thus, it results in the slowing of the price increase and cooling of the economy.

Circumstances in which the US Federal Reserve increases interest rates:

The Federal Reserve aims to keep the US economy just right. When the economy booms or is running hot, we may experience inflation pressure, and asset bubbles can be beyond our control. Thus, it could be a threat to economic stability. In such a situation, the Fed pitch in and increases the interest rate, which helps to cool the economy and keep growth on track.

Federal Reserve’s highest and lowest interest rate:

However, from March 2022 onwards, the Fed started increasing the interest rate to curb the inflation rate. Russia’s war against Ukraine is causing tremendous human and economic hardship. The war and linked events continue to create upward inflation pressure and are weighing on global economic activity, which is forcing the Fed to increase the interest rate. 

Related Link: FED increases primary credit rate by 0.75%

Consequences of the US Federal rate increase:

1. Stock market: The stock market reacts strongly to even a small change in the Fed rate. A slight drop in the interest rate prompts markets to move up as the borrowing cost of the companies goes down. But at the same time, investors also try to understand the statements given by the FOMC members to know where the target rate will move.

2. Treasury bonds: The value of treasury bonds is directly linked to any changes in the interest rate. If the Fed rate increases, the treasury bonds prices move down immediately. This is because new bonds will come into the market, offering investors higher interest rate payments.

3. Saving and bank deposits: When the interest rate increases, it is good news for people saving in the bank compared to the borrowers. When FOMC increases the interest rate, banks also increase the amount the person earns from the deposit. These could be a savings account, checking accounts, certificate of deposit, and money market.

Why the ASX 200 ended high despite the increase in Fed rate?

If we go by the theory, ASX 200 should have dropped the next day of the announcement. On 28 July 2022, ASX 200 closed up by 0.97% and settled at 6,889.70. The inflation moved up 6.1% and was the biggest increase in the last 10 years. Still, the index moved up, why?

The answer is because of the recent predictions by economists who were expecting the number to be 6.3%. Thus, indicating less damage to Australian customers, small bad debts for the big 4 banks, and less impact on valuations in general.

Do Watch: https://www.youtube.com/watch?v=JM9Sp7feE8U

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