On June 15, 2022, the US Federal Open Market Committee (FOMC) did something it hasn’t done since 1994 – it hiked the Fed Funds rate by 0.75%. So, what does that mean?
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A Fed Hike means that the voting members of the FOMC voted to increase its target for the key policy rate of the United States, the US Target Federal Funds Rate, known as the Fed Funds rate for short.
A hike in the Fed Funds rate is one of the key monetary policy levers that the Central Bank has in its arsenal to slow down inflation by making it more expensive to borrow. This, in turn, can also apply the brakes in an overheating economy.
Generally, rate hikes mean that the economy is approaching the peak of the economic cycle.
The Target Federal Funds Rate, called the Fed Funds rate for short, is the main policy rate of the United States of America.
This is the rate that the Fed targets as the overnight lending rate between member depository institutions on an unsecured basis to ensure they meet reserve requirements. This sort of lending and borrowing between banks and other financial institutions is commonplace as end-of-day balances fluctuate.
The decision on whether to leave the Fed Funds rate unchanged, to hike or cut the rate and by what magnitude is undertaken by the FOMC when it meets 8 times every year – although we have also seen emergency unscheduled meetings, most recently in March 2020 during the start of the COVID pandemic.
This committee is led by the Chair of the Federal Reserve and is comprised of 12 voting members:
Inflation is an economic concept that refers to increases in the price level of goods over a period. We see inflation occur when too much money chases too few goods or services. A little bit of inflation in the economy over the long run is a healthy thing. As a matter of fact, the FOMC has an inflation target of 2% annually in addition to its other mandate to maintain strong employment.
However, if inflation is left unchecked, means that prices can get out of hand and possibly create bubbles, as we saw in US housing prices before the Subprime Crisis, or even hyperinflation, which can cause the economic collapse of a country. A little too much inflation can also make consumers’ lives difficult as the rise in the price level means less can be bought with the same amount of money.
So how does the FOMC hiking rates lower inflation?
Firstly, as the rate that banks and other financial institutions need to lend or borrow at increases, the rates that these banks will pay or charge their individual and corporate customers will also increase. Companies and families may delay making expenditures if their borrowing costs increase. Mortgage rates will also rise, making it more costly to buy a home.
Remembering that inflation is caused by too much money chasing too few goods or services, a Fed Funds rate hike also causes some investors, namely those looking for interest income, to leave their money at the bank to earn that higher rate of interest. This causes a decrease in the money supply, which also helps to alleviate inflation pressures.
Another way that higher rates lower inflation in an economy is by making the domestic currency stronger. A Fed Funds rate hike means the returns that an overseas investor can make by moving their foreign currency into now higher-yielding US dollar-denominated assets, such as US government debt.
In order to do so, these investors would need to exchange their foreign currency into US dollars, thereby making the USD stronger. This in turn makes US goods exports more expensive and less attractive to their trading partners, slowing down US factory orders.
Generally speaking, rate hikes are not “one-and-done”. Central banks like to promote stability, so rate moves tend to be slow and systematic because the downside in making an error with rate moves is very significant. Hence, once a Central Bank starts rate hikes, they tend to persist for a while.
After 2011, the FOMC releases a “dot plot” after its meeting, which gives forward guidance on the expected direction of rate movements – whether they are lower or higher. Expectations are important because not only do they calm the economy that the Fed will do what it takes to bring inflation down, but it also has the more important effect to impact the expectations of people in financial markets.
Let’s break down this section into two parts. The first is for the individual and the second will deal with capital market securities.
From the credit perspective, we mentioned that hiking rates will impact lending rates. For an individual, that means that car loans and credit card debt will become more expensive, especially if the Fed continues to hike. Large expenditures might be postponed if plans were to finance the purchase.
As rates move higher, banks and mortgage providers will charge higher mortgage rates. This may be a double-edged sword as this may help cool a hot housing market, as higher borrowing costs might dissuade speculators. On the other hand, the housing supply, which is already tight in many markets, may get tighter as builders delay projects.
For savers, the rate hike may prove to be a positive. Banks and other financial institutions will likely offer higher deposit rates. For those investing in capital markets and other financial assets, a higher Fed rate means that certain instruments will also return higher returns. Let’s look at these next.
A Fed hike means that the US dollar should appreciate since all things being equal, returns in US fixed income products should increase as the market reprices the effects of the rate hike and subsequent hikes.
We would expect the yield curve to bear flatten after seeing a bear steepening earlier this year in anticipation of rate hikes. The bear flattening means that interest rates in short-dated bonds move higher as compared to the longer maturity ones. This means prices for bonds, especially those in the shorter maturities, will fall since there is an inverse relationship between price and yield in fixed income.
Simply put, investors would rather purchase a new bond with a higher coupon reflecting the higher interest rate environment than an older bond issued with a lower coupon. Hence, the older lower coupon bonds would have to sell cheaper to make the investor interested.
There is a class of fixed income securities called TIPS (Treasure Inflation Protected Securities) that adjusts to account for the impact of inflation. As the Fed is clearly committed to lowering inflation, these TIPS would also be expected to fall in price.
When it comes to commodities, if the Fed manages to slow down inflation, the price of things such as oil, rare earths, and agriculture would also be expected to fall, not only due to slower end-consumer demand, but also a lowering of the inputs required to produce these commodities.
Lastly, when it comes to stocks, Fed hikes generally signal the peak of the economic cycle as rising borrowing costs drive down business growth and expansion. So, despite the reassurance of the Fed to calm markets and engineer a soft-landing for the economy, stocks should underperform.
This underperformance may be more severe for certain sectors, such as growth stocks, energy companies and real-estate-related companies. Also, rate hikes drive investors to fixed income markets as well, which may mean the selling of equities into bonds.
On the other hand, there are sectors that tend are do better in a rising rate environment. Rising rates generally mean higher profit margins for banks and other financial institutions, resulting in better results. Defensive sectors, such as consumer staples, utilities, and health care, tend to be less cyclical as consumers will always need things like food, utilities and medicines.
Although a new asset class, cryptocurrencies should not be immune to Fed hikes. For those who argue that digital assets provide a hedge against rising inflation, the Fed’s intent to lower inflation is not a positive factor. For those investors that used borrowed money to lever their investments in crypto assets, rising rates mean lower returns. Moreover, as the risk appetite of the market falls, investors tend to shun high volatility investments.
You might wonder why would the FOMC ever decide to hike rates? The reason is hyperinflation. If too much money chases too few goods or services for too long, the economy would destabilize as the purchasing power of a unit of currency would fall from day to day, making it difficult to price even simple necessities, like a loaf of bread. For example, in post-World War 2 Hungary, prices doubled every 15.3 hours.
Another situation that the Fed doesn’t want to find itself in is stagflation. This term is used to describe slow economic growth and employment (stagnation) coupled with a rising level of prices (inflation). Stagflation is widely regarded to be much worse than recession, as the traditional monetary policy tool of cutting rates to boost economic growth would actually cause more inflation.
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