What Happens When the Fed Raises the Interest Rate?

What is Interest Rate?

Interest rate is a percentage charged on the total amount of money you borrowed from banks which represent the cost of borrowing. Also, it is a percentage earned on the total amount of money you saved in bank, representing the reward for saving.

Why Would the Fed Control Interest Rate?

The U.S government is worrying about the 5.4% inflation in 2021. Normally, an inflation that is healthy and stable for an economy is between 1 and 3%. Hence, the Fed would like to control inflation to avoid panics in the economy.

Also, if an economy enters recession, one of the ways to bring the economy back to normal is through monetary policy. The Fed can decrease the interest rate to incentivize businesses and individuals to borrow money for consumption and investment to boost GDP.

How Does the Fed Changes Interest Rate?

The Fed can buy securities from banks to lower interest rate. This is because when securities are bought from banks, the banks receive cash, and their reserve ratio increases above the required ratio. Hence, it would lower the interest rate sets by banks to attract more business and individuals to borrow.

If the Fed would like to increase interest rate, it can sell securities to the banks. The banks would pay the Fed cash in exchange of securities. This would forces the banks to borrow funds from the fed to meet the reserve ratio requirement, this would increase the interest rate.

Impact on Stock and Bond Market

If the interest rate increases, this would make borrowing money from the bank more expensive. Hence, businesses and consumers would borrow less or not borrow at all. This would lead to a decrease in spending and investment, causing earnings to decrease and the stock price would decrease.

If the interest rate increases, the risk in buying bonds would increase, hence increase the bond yield. This would lead to a decrease in stock price.

Impact on Saving Accounts

As discussed above, interest rate is the reward for saving. If interest rate increases, this would lead to an increase in the earnings on saving. This includes saving accounts, checking accounts and certificate of deposit.

Foreign Effect of Higher U.S Interest Rate

Expected increase in the U.S interest rate has affected the Asia market. Japanese blue-chip stock average dropped by 400 points, or 1.4%. Also, Japanese Yen weakened, hitting 2-months low of 110.8 yen per dollar. Besides Japan, South Korea’s Kospi Stock index also declines by 0.4% and Samsung share decline by 1%.

Conclusion

The expected increase in the U.S interest rate certainly have huge impact on every aspect of the economy. It would decrease the stock and bond price, increase earnings on saving accounts and impact financial markets abroad.