Fed Rate Explained | 4 Things To Know About The Fed Rate

Transcript

If you follow the US markets, some time or the other you would have definitely come across news about the Fed rates increasing or decreasing. In this video we are going to be diving deeper into Fed rate increases, specifically or hikes. This is an event which is likely to impact your market returns in 2022.

So, first let’s start with the basics. 

The Fed or the Federal Reserve is the central bank of the US. The Fed rate or the federal funds rate refers to the rate at which banks in the US borrow or lend their excess reserves to other banks overnight to other banks. This rate is set by the Federal Open Market Committee and The Fed typically hikes or reduces this rate to control the amount or the supply of money in the economy.

4 Things to know about the Fed rate hike

So for today’s video, we’ll discuss four things you should know about Fed rate hikes. So that you can make better informed investment decisions. 

1. How the Fed uses interest rate hikes

First, let’s understand how the Fed uses interest rate hikes. The Fed’s main job is to basically manage the monetary policy for the United States, which basically means controlling the supply of money in the economy. And interest rates are a tool that the Fed uses to control this money supply. Interest rate hikes are used by the Federal Reserve to decrease the supply of money in the economy while lowering interest rates has the opposite impact. What does the Fed achieve by managing this kind of monetary policy? 

There are basically two goals that they have: The first is to ensure maximum employment for the citizens of the US and the second is to ensure stable prices, which is also referred to as low inflation.

2. Why Fed increases interest rates

Alright! So, second, let’s understand why the Fed increases rates. The Fed decides to hike interest rates particularly when the inflation in the economy is on the higher side and the unemployment rate is low. 

When interest rates are higher, what it leads to is basically an increase in the cost of borrowing right? across the economy, which then makes taking loans expensive both for businesses that want to raise money as well as for consumers that want to borrow. Now businesses that cannot afford the high cost of loans would then postpone their plans to new projects.

Whereas higher interest rates also encourage individuals or consumers like you and I to save more money so that they can earn a higher rate of interest on their savings. The overall effect, the combined effect of both of these is that the money supply in the economy reduces. Because people are not borrowing, not investing in new projects. Also, consumers are saving more and more and not spending that. This tends to decrease inflation and cool down the economy.

3. How Fed rate impacts stock market

Next, let’s take a look at how the fed rate hike actually impacts the stock markets. The impact might actually be adverse on the equity markets. And why is that? As we saw earlier, higher interest rates make it much more expensive for both businesses and consumers to borrow money.

Now, as a business, the rise in the cost of doing business may actually lead businesses to actually lowering investments and in turn having lower revenue growth, as well as lower earnings growth for all of these public companies.

4. Market volatility

An additional impact of interest rate hikes is that the markets might become much more volatile. And that has been the case since December 2021, when the Fed signaled that we are going to be increasing rate hikes in 2022. However, there is not a direct relationship between rate hikes and the stock markets. The impact could actually be felt after a lag.

Finally, let’s understand how a Fed rate hike may actually impact global markets, not just the US market. 

Typically Fed hikes also tend to impact the markets across the world, especially the emerging markets. In the past, a rate hike has resulted in foreign investors pulling out of emerging markets and actually moving their funds to less risky assets like the US treasury bonds.

They do this because these kind of assets now provide much higher returns and less risk. So, a fed rate can lead to capital outflows and currency depreciation in emerging markets. 

Alright, in this video we saw why it is important to be aware of fed rate hikes and their potential impact when you are investing in the US stock markets.