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How Do Fed Rate Hikes Affect the U.S. and Global Economies? | Trading Forex

The uncertainty of whether or not the Federal Reserve will raise interest rates has set global markets on edge for most of the past year. With a December hike looming—one that will move the current rate away from its current zero percent and will be the first increase since 2008--more and more central banks have put their own activity on hold in anticipation of a Fed decision.

What is the significance of an interest rate hike and why is the Fed move so pivotal at the moment?

The Federal Reserve Bank is the central bank of the United States. One of its major functions is to control monetary policy and it does this by increasing interest rates when the economy is growing too fast. This encourages people to save more and spend less, strengthening the dollar and reducing inflationary pressure. Conversely, when the economy is in a recession or growing too slowly, the Fed reduces interest rates to stimulate spending, which increases inflation.

With a December hike looming… more and more central banks have put their own activity on hold in anticipation of a Fed decision.

Inflation Control

The Fed uses its control of monetary policy by setting a specific inflation rate which it believes will maintain stable consumer spending and the correct level of employment. When the economy is weak, inflation naturally falls; when the economy is strong, rising wages increase inflation. In 2011, the Fed officially adopted a 2% growth rate in order to help the economy grow at a healthy rate.

When the Fed introduced a near zero interest rate during the financial crisis in 2007, it expected inflation to increase steadily over the years. However, this failed to happen and now in 2015, inflation is still well below the 2% target, which is contrary to the normal effects of low interest rates. The reasons cited for low inflation in a low interest environment are falling oil prices and global economic crises.

A low interest rate helps businesses to expand, which in turn leads to more jobs and greater consumption. Under normal economic conditions, increases in the federal funds rate reduce inflation and increase the appreciation of the U.S. dollar. In addition, when the Fed increases interest rates, it attracts foreign funds to the U.S. which leads to a natural appreciation of the U.S. dollar, despite stagnant wages and low domestic consumption.

An interest rate hike now, with the 2015 economic environment as it is, will keep the growth of inflation close to the 2% benchmark while increasing the dollar’s appreciation.

How will an interest rate hike affect the American consumer? Higher interest rates work in two directions. On the one hand, higher rates will provide increased savings on bank accounts and long term treasury bonds. Certain other investment vehicles will also reflect this higher rate.

On the other hand, most consumers will feel the increase in their mortgages, bank fees, car loans and all other short term borrowing programs.

With lower gasoline prices at the pumps, however, consumers are already finding extra spending money in their pockets and together with a strong stock market and a job market that continues to improve, the overall mood among the public should continue to be positive even with a small rate increase.

Effect on Foreign Economies

Increasing interest rates go hand-in-hand with appreciating currencies. This affects economic facets domestically and around the world—particularly the credit market, commodities, stocks, and investment opportunities.

In many parts of the world, the US dollar is used as a benchmark of current and future economic growth. A strong dollar is seen in a positive light in developed countries where rising interest rates benefit from foreign trade by boosting US demand for products around the world, increasing corporate profits for both domestic and foreign companies. And because fluctuations in the stock market project views about whether industries will grow or contract, the resulting profit increases should lead to stock market rallies.

Emerging Markets

In emerging economies, reactions to an increased Fed interest look different.

A Fed rate will increase concerns in emerging markets which are already anxious over the effects of a surging dollar and capital outflows. The year has already been a tough one for many of the emerging economies with the continued slowdown in China and tanking commodity prices in countries that depend on them the most for their overall economies.

Higher interest rates strengthen the dollar against other global currencies and attract capital away from emerging markets, where $4.5 trillion in gross inflows was reported between 2009 and 2013. If imports slide, governments will find it difficult to fund their debts and business investment will decline.

The huge amount of credit denominated in dollars weighs heavily on government and corporate accounts the world over. Ultra-low interest rates have led borrowers to take trillions of dollars in debt tied to the dollar. If interest rates rise, many of those debts could become unsustainable.

Some analysts fear that a surplus in dollar-denominated credit brought on by a higher interest rate will spur a global debt crisis and credit market volatility has already reared its head.

In addition, since oil, gold, cotton and other global commodities are priced in US dollars, a strong currency following a rate increase would increase the price of commodities for non-dollar holders. This will have an immediate effect on economies that rely primarily on commodity production and an abundance of natural resources. As these products decline in value, their available credit streams will shrink.

Interest rates are fundamental indicators of an economy’s growth. In the US, the Federal Reserve’s move to increase interest rates is expected to spur growth and enthusiasm by investors, while moderating the economy itself. While the Fed’s main concern is the US economy, it will not be able to avoid watching closely how the effect of its rate increase will play out on foreign trade and on the world's credit and commodities markets.

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