Interest Rate Modulation, an Everlasting Practice

Interest Rate Modulation, an Everlasting Practice

When it comes to interest rates, the market never stops paying attention. And it is understandable: The Federal Reserve, through its monetary policy, has an influence on the entire economy, at all levels.

Let's examine why the Federal Reserve intervenes on rates, its history, and what are the results.

Interest rates, an economy stabilizer

In a nutshell, the Federal Reserve's objective is to maintain a healthy and productive economy. When the economy enters a recession and expansion stalls, the Fed can reduce interest rates to promote expenditure and development. In contrast, when the economy is thriving and inflation risk increase, the Fed can increase interest rates to protect the economy from boiling.

The objective is to maintain components of the economy within appropriate targets, such as inflation or employment, while responding to market cycles and external factors such as major conflicts, market disruptions, and other major occurrences. The Federal Reserve may increase interest rates to counteract ongoing inflation, or merely to stabilize the economy after a period in which rates were purposefully decreased.

Raising and reducing rates requires a delicate balance. A poor choice might have significant short-term repercussions. The Federal Reserve acknowledges that in order for its policies to have a beneficial effect on one component of the market, they may have a negative effect on another. In recent times, the Federal Reserve has been cautious to declare its plans beforehand in an effort to minimize market responses. Some economists claim that disclosing measures in advance diminishes the impact of rate changes on economic output, despite the fact that it may lower market players' responses.

Changes in interest rates, here are the effects

To increase interest rates, the Federal Reserve modifies its overnight lending rates to banks. This causes a domino effect that influences the interest rates charged by banks to companies and consumers. The effect of rising interest rates on an economy is as follows:

  • Consumer borrowing rates rise, reducing spending, house purchases, and investments.
  • For firms, such increase results in less spending in new operations, marketing, expansion plans, and others.
  • Interest rates on low-risk assets (such as savings accounts) rise, making investments in those products more appealing.
  • The markets respond, with fixed income assets usually losing value and stocks reacting inconsistently to the anticipated effect of increased interest rates on some kinds of businesses.

Important historical events

In the last 70 years, Fed rates have remained below 2% for a sizeable duration, the majority of which occurred between mid-2008 and end-2018. It was by far the lengthiest period when rates were below such level, consistently.

In 2008, in reaction to the global turmoil and subsequent collapse of the financial and housing markets, the Fed reduced interest rates. The latter, which was above 5% for the majority of 2007, decreased to approximately 2% by the middle of 2008, and then fell to 0.12% at the end of the year.

It is also critical to mention the year 2020, when the Covid-19 outbreak sent the global economy into a tailspin. To offset the adverse economic effects of the pandemic, the Federal Reserve further decreased the interest rates, and the government distributed stimulus payments to the population – The rate was reduced from 2.5% in 2019 to 1.5% in the beginning of 2020.

Fed Funds Rates, 1950-2020Figure 1: Fed Fund Rates, (1950-2020). Source: Macrotrends

On the other hand, highest rates were recorded in 1980, when the Federal Reserve was combating inflation. In January 1980, the Fed rate started the decade with a target rate of 14%, and in December 1980, authorities increased the goal range to 19-20%, the highest level in history.

Interest rates and investing

Increasing interest rates have both structural and perceived effects on investments. For many investors, the forecast for inflation and whether it will be transitory or permanent exacerbates the problem. In addition, investors must consider the geopolitical uncertainty surrounding the crisis in Ukraine and the forthcoming midterm elections.

In terms of rates alone, increased rates are predicted to have the following effects:

  • As interest rates increase, bond and other fixed income investment prices will decline, particularly for longer-term securities.
  • The interest rates paid on new bonds will rise, making them somewhat more competitive with stocks.
  • Increasing rates on bank products such as CDs would make them more appealing to investors. Overall, increasing rates should decrease speculative exuberance due to greater borrowing costs.
  • Unemployment might grow.
  • The possibility of increasing interest rates may also influence the behavior of investors, many of whom may opt to postpone credit purchases or sell equities acquired on margin, based more on their expectations than on the immediate state of affairs.

Inflation vs. the Historical Target Range for Rates

The inflation rate has been climbing steadily over the last several months. Nonetheless, the Fed preferred not to overreact by chasing inflation with excessive rate hikes in the immediate future; however, its stance on this issue is becoming more hawkish lately as the underlying forces of inflation continue to persist. At the meeting in June 2022, the Fed increased the funds rate to a range of 1.5% to 1.75%. As a result, even if rates keep on increasing, they will only rise back beyond the 2% line and thus, stay at the lower end of the historical target range of 2-6%.

 

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