The US Federal Reserve on Wednesday, July 27, decided to raise the key interest rate by 75 basis points, to 2.25 – 2.5 percent per annum. The regulator considers it appropriate to further increase the rate. In addition, the Fed’s Open Market Committee will continue to reduce its holdings of Treasuries and mortgage-backed securities.
What are Federal Reserve Interest Rates
According to the requirements of the US Federal Reserve, every US bank is required to have a certain amount of cash reserves. These funds are for customer transactions. If at some point customers want to get their deposits in hand, and the bank does not have the funds for this, then we can become witnesses of another banking crisis in the economy. For this reason, the Fed establishes precise guidelines for the size of reserves.
Every day, banks carry out a huge number of transactions, and each bank is interested in increasing the volume of its transactions for greater benefits (on commissions, etc.). There are times when one of the clients unexpectedly says “I need money desperately today” and then withdraws a significant amount of money from their bank account. In this case, the volume of the bank’s reserves is reduced and does not meet the requirements of the Fed, which, ultimately, may promise such a bank a number of problems.
The Fed has increased the discount rate by 225 basis points so far this year, starting in March. The majority of Fed officials claim that the base discount rate at this time has a “neutral impact” on the economy. The period of “cheap money” that flooded into the US economy to deal with the effects of the COVID-19 pandemic has come to an end as a result of the rate’s sudden and large increase.
It took just four months for the rate to reach the peak of the previous Fed tightening cycle, which lasted from late 2015 to late 2018.
Reasons for the Change in Interest Rates
The number of jobs being created has significantly increased recently, and the unemployment rate has remained low. The pandemic-related imbalances in supply and demand raised prices for food and energy, and broader pricing pressures are all contributing to the continued high inflation rate. By the end of June, consumer prices in the United States rose by 9.1 percent in annual terms, which is the largest increase since December 1981.
Russia’s conflict with Ukraine is having a terrible impact on both people and the economy. Inflation is being further pushed upward by the conflict and its accompanying events, which is putting pressure on global economic growth. The FOMC pays close attention to the risks of inflation.
The FOMC will keep an eye on how new information will affect the outlook for the economy as it determines the best course for monetary policy. If dangers arise that could obstruct the FOMC’s objectives, the FOMC would be prepared to change the stance of monetary policy as necessary. In addition to readings on public health, labor market circumstances, inflation pressures, inflation expectations, and financial and international developments, the Committee will consider a wide range of facts when making its determinations.
Over the long run, the FOMC aims to attain maximum employment and inflation at a rate of 2%. The FOMC agreed to increase the federal funds rate target range to 2-1/4 to 2-1/2 percent in support of these objectives, and they think that further increases in the target range will be appropriate.
As stated in the Plans for Reducing the Size of the Federal Reserve’s Balance Sheet released in May, the FOMC will also keep cutting back on its holdings of Treasury securities, agency debt, and agency mortgage-backed securities. The Committee is adamant about getting inflation back to its 2 percent goal.
Why Do Rising Rates Put Pressure on Inflation?
The United States has experienced numerous cycles of rate rises and rate decreases throughout its history. Investors are especially concerned about the cycle of rate increases since historically, rates have been increased to maintain a strong economy. An increase in rates is a response to inflation that is significantly higher than the target “normal” rate.
The interest rate on loans and savings unavoidably rises as the rate does as well. Households and regular people are moving money away from high-risk assets and into safe accounts as deposit rates climb as the latter start to offer more alluring returns.
As a result of rising interest rates, banks start to draw in already expensive capital (increasing compensation to depositors), which raises lending interest rates as well. On the other hand, there are fewer loans being issued since an increasing number of applicants are unable to secure financing at high-interest rates.
The slowdown of the inflationary processes in the economy is caused by the economic cycle slowing down as a result of the reduction in credit issuance.
What Happens When the Interest Rate Rises?
The outflow of portfolio capital to other nations increases when US interest rates rise. And this implies a drop in the value of local assets (and, for example, an increase in bond yields). Thus, it is conceivable that interest rates will start to rise in other states as well.
As a result, issues with loans made during the epidemic, when the reference rate of national banks dropped to nearly zero, will only get worse. Now that interest rates on these loans are rising, a lending crisis in the mortgage and other sectors may result.
As we can see, the growth of the Federal Reserve interest rates in the USA was caused by many factors that accumulated over a period of time. The current actions of the Fed are aimed at normalizing the level of inflation in the country. However, at the same time, it had a significant impact on other countries whose economies are based on dollars. Therefore, it is almost impossible to accurately assess the impact, and even more so, of further changes in the interest rate, due to the rapid development of events around the world.