How Interest Rates in America Affect Us

  • Posted by Sean on October 13, 2015 in Banking Economic Market

After two days of debating, the United States Federal Reserve (the Fed) decided not to raise the Federal Funds Rate at its Federal Open Market Committee meeting on the 17th September. Their next meeting is set for the 28th of October, keeping financial traders, analysts and international businesses on their toes. But why is the Federal Funds Rate important to anyone outside of the US? Well, we’re going to explain that – along with some predictions as to what will happen to the rate. USD chart

The Federal Funds Rate

The large banks have accounts with the Fed. The end-of-the-day balances in these accounts are used to meet the reserve requirements set by the Fed. If a bank expects to have a larger daily balance than it needs, it can lend the extra to an institution that expects to have a shortfall in its own balance. The interest rate set by the Fed, known as the Federal Funds Rate, represents the interest rate the bank has to pay to borrow this money. Since the Federal Funds Rate is the banks’ interest rate, this trickles down to everyday borrowers like you and I – since the banks pass on the cost quickly. While most loans aren’t directly tied to the Federal Funds rate, interest rates generally move in the same direction.

How Do Interest Rates Affect The Currency Markets?

If you don’t live in America, you might be wondering how you’re impacted by this. As interest rates go up in the US, overseas investors see an opportunity to increase the returns they’re getting on their investments. These investments increase the demand for the USD, causing it to appreciate when compared to other currencies (such as the EURO).

USD EURO CurrencyThis means you’ll get more EUROs when you cash in your USD, but less USD when you cash in your EUROs. Further to this, the Federal Funds Rate is a telling sign as to what the experts think of the state of the economy. Increasing interest rates, which increases the cost of borrowing, slows down the over-demand that drives inflation.

If officials are increasing the Federal Funds Rate, it appears that they believe inflation will increase in the near future. Since the US is such an economic leader, these signs are immediately priced into the global currency and stock markets, altering the value of the USD and the currency of its global business partners.

So Will the Fed Raise Rates?

“Will the Fed raise rates?” is literally the million, or even billion, dollar question. Although, many economists believe the more appropriate question is “When will the Fed raise rates?” As things currently stand, the Federal Funds Rate currently sits at 0.25% – with no raise since June 2006 (before the dreaded Global Financial Crisis).

Essentially, the Fed is waiting for signs of a strong economy. Recently released US employment figures were underwhelming (you can find these here) and indicate that the US may not be as “rock solid” as experts have thought. Adding to this are other global concerns: the Chinese Yuan devaluation and stock market turmoil coupled with falling oil prices, creating uncertainty and fear in the worldwide financial markets. Despite this, the US has recovered from the Global Financial Crisis (GFC) of 2008 and many experts argue that a rate rise is necessary to avoid mass credit growth (as increasing interest rates raises the cost of borrowing money) and prevent future economic downturns like the GFC.

Even with currently low inflation (0.2%), the Fed is targeting inflation of 2% by 2018 – it may increase rates to maintain this. Many international central bankers favour a hike and have done all that they can to prepare, such as letting their currencies float to absorb inflation for cheaper imports. It appears the rest of the world sees a hike as guaranteed and would prefer a quick execution of this, as opposed to having to wait for the inevitable.

It may well be that the Fed will hold off on raising rates until early next year, or even later, but it’s difficult to say. Goldman Sachs, one of the US’s largest investment banks, pegs the chance of an October rate rise at around 8% likelihood, though a rise before December next year is predicted to be a little over 90%. In fact – they believe there’s a sizeable chance that the Fed will raise rates twice between now and the end of next year.

While an October rise seems fairly unlikely in spite of things, it can’t be entirely ruled out. The world will watch for the Federal Open Market Committee meeting on the 28th of this month – the results may well surprise us.

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