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Impact of Fed Rates

Over the course of the last couple of months there has been a lot of talk about a possible Fed rate hike. The reason for this is due to its importance on a global level, hence why do stocks all over the world usually move in line with news concerning the hike?

Economies are becoming more and more dependent on one-another that any national policy movement has to be taken into consideration. As the US is one of the most important global economies this need is amplified.

For those that do not understand what the Federal Reserve is and how Fed rate is determined I will briefly define key terms and explain the mechanism behind it.

The Federal Reserve Bank is the central bank of the United States. They have the power to manipulate the federal-funds rates. The federal funds rate is the rate at which depository institutions can lend federal funds, the balance they hold at the Federal Reserve, to one-another. These loans are typically overnight and uncollateralized. The interest charged on these overnight loans can actually differ across loans which is why a distinction needs to be made between federal funds rate and effective federal funds rate.

The effective federal funds rate is simply the weighted average of all federal funds rates charged. The way in which the Federal Reserve can manipulate this rate is through open market operations, in which they influence the money supply in the economy such that the rate follows their target. In the instance of a rate hike, the Fed decreases the money supply. The effect of money supply on interest rates can be seen in the simple diagram below which plots both money demand and supply.

The US has been criticized as they keep the financial markets guessing when the hike will actually occur. One of the most important functions of a Central Bank is to provide certainty in their policies to enhance their credibility which can reduce the time lags of their policies.

But finally markets are able to approximate the time of the hike which is likely to be by December of this year. The reason for the delays is due to the global economic climate. Janet Yellen, the head of the Federal Reserve, said that the hike has been continuously placed on hold due to the developments in the emerging markets.

This highlights the dangers that this hike could pose for the emerging markets who are already suffering an economic downturn. Capital outflows have been persistent in the wake of a hike as an increase in US interest rate will cause the dollar to strengthen, devaluing their currency. Moreover, many corporations in these markets have dollar denominated debt which can undermine their profitability.

As seen in the last couple of decades, many countries are forced to adapt their monetary policy to that of the US. A country that is likely to follow is the UK. The graph below illustrates how their monetary policies are consistently in line with each other. The UK can afford to follow policy since they are showing strong recovery and have a strong labor market like that of the US. By increasing their rates, they can enjoy some policy freedom in the future as current rates are extremely close to 0%.

Other countries are very unlikely to follow, not many countries have the same underlying fundamentals as that of the US and UK. Emerging economies, for instance, must stimulate confidence in their economy which at this point in time can only be done through expansionary policies. They are likely to combat the hike by reducing their interest rates to boost investment and dissuade investors from fleeing their capital markets. And as for the rest of the world, they are also likely to pursue expansionary policies due to worryingly low inflation caused by declining oil prices.

The US too may be harmed by their own policies. An increase in the interest rate could cause China to vastly reduce their holdings of Treasury bonds which would create funding shortfalls for the US. Moreover, corporate defaults are likely to increase in line with the cost of debt, however, many corporations are renewing their sources of financing to lock-in pre-hike interest rates. Lastly, their energy sector could be severely harmed as they already have to deal with declining oil prices.

It is obvious that the national policies of the US will impact the global economy and it will be interesting to see how economies will respond to an interest rate hike that has not been seen since 2006. No one can forecast with certainty the adverse effects it will have.




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