Interest rates of federal reserve

The current study’s primary goal was to assess and correlate current affairs to the impact of Federal Reserve interest rates – a percentage at which lending institutions advance reserve balances to other lending entities on a daily basis. Reserves were new balances held with the Federal Reserve System in accordance with the Federal Reserve System’s monetary policy provisions (Investopedia, 2017). The Fed rate is used by the US government as a policy tool to direct future development opportunities and economic results. Notably, the Fed rate was adjusted regularly to reflect the financial and monetary policies that in turn influenced key economic indicators such as inflation, annual economic growth, and the rate of employment. In particular, the Federal Reserve System dictated the open market approaches, reserve regulations, and discount rate (The Federal Reserve, 2017a). The Federal Reserve rate is adjusted at least eight times in a year by the Federal Open Market Committee. In November 2017, the Federal fund’s rate was pegged at 1.16 (The Federal Reserve, 2017b). A detailed analysis of the relationship between the Federal rates and the current economic events in the US and around the world were discussed in the literature review section.

Literature Review

The role of the Federal interest rates was elucidated during the global financial crisis in 2008. The FOMC decided to depreciate the Fed rate to 0 - 25 basis points (Gagnon, Raskin, Remache, & Sack, 2011), with the aim of catalyzing growth during the recession. Notably, the Fed rates remained low until 2015, when the Fed rates were normalized to about 0.25 percent (Chong, 2016) ending a 7 year hiatus. Besides, the Fed system further reduced the rate of private borrowing by purchasing significant portions of long-term maturities. It was noted that the strategies adopted by the Fed largely contributed to the stabilization of the economy through the management of inflation and stimulation of economic activity (Gagnon et al., 2011).

Other fiscal measures that were instituted by the Fed system during the great recession included the purchase of debt. In particular, the Fed purchased mortgage securities and housing agency debt up to a cap of $0.6 trillion. Besides, the Fed system also bought medium-term and long-term treasury bonds; the aim of these measures was to boost investments in real estate, which was one of the key drivers for economic growth. Investments in real estate were facilitated by the lower cost of credit (lower interest rates) which had been regulated by quantitative easing policies (Krishnamurthy & Vissing-Jorgensen, 2011). Quantitative easing was either achieved using signaling, default risk and safety channels among others. The impact of the broad asset purchases by the Fed on the US economy was primarily in the form of lower cost of credit and the sustenance of economic growth.

Impact of Non-Zero Interest Rates

The rising of the Fed rate from zero had a global impact because the US dollar was still the main international trading currency. It was projected that the hiking of the Fed rate would have two potential effects namely the appreciation of the local currencies in line with the US dollar and the initiation of national fiscal policy measures aimed at maintaining a competitive exchange rate to the Euro, yen, and RMB (Yueh, 2015). In addition to the potential impact on the international exchange rates, it was deduced that a hike in the Fed rate would increase the cost of borrowing. A higher cost of borrowing would increase risk aversion among investors and it would make it much more expensive for countries to service international debt (normally paid in dollars) due to the appreciation of the USD. Therefore, any increase in the Federal Reserve rate would most likely trigger a fiscal crisis, especially in emerging economies.

A study on the impact of the Federal rate tapering on emerging economies (such as China and India) ascertained that the proposed de-escalation in long-term security purchases by the Fed would result in a significant stock market decline, reserve losses, and currency depreciation. Notably, the devaluation of the currency was relative to the level of increase in the exchange rates prior to the tapering (Eichengreen & Gupta, 2014). Additionally, it was noted that the adverse effects on the economy were correlated with the size of the financial markets. A more pronounced depreciation of the stock market, foreign reserves, and exchange rates were observed in countries with a robust market with significant FDI. Chong (2016) noted that higher interest rates would also adversely affect trade in the ASEAN region. Besides, Eichengreen and Gupta (2014) noted that precautionary control measures instituted by the national governments did not insulate the emerging economies from the domino effect caused by the tapering proposed by the Fed. Besides, the increase in the Fed rate also had a long-term impact on advanced economies. For instance, a two percent surge in the Federal Funds Rate would force most UK citizens to cut back on household spending or borrow more money (Bank of England, 2017).

In particular, it was noted that the hike in interest rates would significantly affect the Chinese economy because investors currently prefer to purchase US government securities because of the projected higher returns and diminished risk. Given the fact that both advanced and developing economies converted part of their wealth in long-term US securities, it was deduced that the demand for US treasury bonds and bills would be higher, and in turn the cost of the US dollar (Graceffo, 2017). The demand for US securities was partly informed by the fact that the US securities market was the largest in the world. The Japanese and Chinese economies came in second and third position respectively. Therefore, the Chinese securities sector was the third option for global investors. However, the low-interest rates offered to investors were some of the key deterrent measures. Besides, higher incidence of nonpayment by Chinese government corporations had weakened China’s credit risk (Graceffo, 2017). Besides, in the recent past, the Yuan’s value had significantly depreciated relative to the dollar due to a slump in economic growth. The value of the trading currency for the securities traded was one of the factors that influenced the investor’s decisions to invest in US securities.

Federal Reserve Rate and the 2008 Recession

At the height of the great recession in 2008, different arguments were advanced on the role of the Federal Reserve rates on the global crisis. On one hand, some argued that the global meltdown was caused by the high market liquidity and other monetary policy tools that were advanced by the Fed (Greenspan, 2009). Notably, the high levels of liquidity contributed to the downturn of the housing sector in the US. However, on the other hand, some argue that the 2008 recession was caused by the low Fed reserve interest rates, which contributed to the widespread speculation in the market. The latter argument was true in light of the fact between 2002 and 2005 the Fed had significantly lowered the long-term fixed-rate mortgage rates. About three years before the recession, there was a high correlation between mortgage rates and home prices in the US, and it predicted the possible occurrence of an economic recession (Greenspan, 2009). Therefore, the prevailing Federal fund’s rate was not solely responsible for the recession. The theory was justified because discounting liquidity was the key determinant for the price of long-term assets. According to Greenspan (2009), the Fed noted the variations between the mortgage rates and monetary policy after the loan agreement rates fell short of responding to the tightening of the Federal policy in June 2004. Additionally, other indicators pointed to a possible recession. For instance, it was noted that the US mortgage market had increasingly become independent of the monetary policies initiated by the Fed system as early as 2000 and 2001. Starting from the early 1970s to 2002, the association between the short-term Federal fund rates and the US mortgage rates had increasingly become proximate as illustrated by the correlation value of 0.85 (Greenspan, 2009). Nonetheless, the close correlation decreased to a statistically insignificant level starting from 2002 to 2005. Therefore, the global downturn in the long-term interest Federal interest rates was attributed to the policy shifts adopted by developing countries between 1990 and 1994. In particular, a large fraction of the developing countries transitioned from centralized planning to an aggressive export-oriented market competition (Greenspan, 2009).

The export-oriented fiscal and monetary policies adopted by emerging economies in the 1990s partly contributed to the outstanding growth of the Chinese economy. Notably, other emerging economies such as Brazil also recorded a marked growth. The spectacular growth among emerging economies resulted in a mismatch between the planned capital investments and the global savings. In particular, the rate of global savings was much higher relative to the capital expenditure. Consequently, actions by investors from China and other emerging economies fueled the appreciation of long-term interest rates around the world (including the US), starting from 2000 to 2005. However, sustained investment in interest contributed to the downturn in interest rates and a capitalization of the long-term mortgage rates. Considering that the real-estate capitalization rates in the US were not founded on sound monetary policies, the real estate bubble collapsed resulting in the worst recession with the exception of the 1930s.

Conclusion

The current research paper elucidated the relationship between the Federal Reserve rates and the real-life economic indicators such as inflation, the rate of employment, and liquidity. Particular case studies such as the role of Fed rate capping on the great recession in 2008, currency depreciation in emerging economies and the recovery of the US economy after the 2008 recession. It was noted that the Federal Reserve adjusted the Fed rate upward or downward depending on the prevailing economic conditions and the monetary policies adopted by the US government. Based on the current economic conditions in the US, it was deduced that the Fed would most likely increase the Federal Reserve interest rate. The forecast was informed by the anticipated Republican tax cuts that would catalyze economic growth.

References

Bank of England. (2017). How does monetary policy work? Retrieved November 29, 2017, from http://www.bankofengland.co.uk/monetarypolicy/Pages/how.aspx

Chong, G. (2016). Rise of the US Federal Reserve’s Interest Rate. In Warwick ASEAN Conference. Retrieved from http://warwickaseanconference.com/rise-of-the-us-Federal-reserves-interest-rate/

Eichengreen, B., & Gupta, P. (2014). Tapering Talk: The Impact of Expectations of Reduced Federal Reserve Security Purchases on Emerging Markets. Munich Personal RePEc Archive, 1–25.

Gagnon, J. E., Raskin, M., Remache, J., & Sack, B. (2011). Large-scale asset purchases by the Federal Reserve: Did they work? Economic Policy Review, Federal Reserve Bank of New York, (May), 41–59. https://doi.org/10.2139/ssrn.1952095

Graceffo, A. (2017). How December’s Fed Rate Hike Impacts China. Foreign Policy Journal.

Greenspan, A. (2009). The Fed Didn’t Cause the Housing Bubble. Retrieved November 30, 2017, from https://www.wsj.com/articles/SB123672965066989281

Investopedia. (2017). Federal Funds Rate. Retrieved November 30, 2017, from https://www.investopedia.com/terms/f/Federalfundsrate.asp

Krishnamurthy, A., & Vissing-Jorgensen, A. (2011). The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy. Brookings Papers on Economic Activity, 2011(2), 215–287. https://doi.org/10.1353/eca.2011.0019

The Federal Reserve. (2017a). Federal Open Market Committee. Retrieved November 29, 2017, from https://www.Federalreserve.gov/monetarypolicy/fomc.htm

The Federal Reserve. (2017b). Selected Interest Rates (Daily) - H.15. Retrieved November 29, 2017, from https://www.Federalreserve.gov/releases/h15/

Yueh, L. (2015). What A Fed Rate Rise Means For The World Economy. Retrieved November 29, 2017, from https://www.forbes.com/sites/lbsbusinessstrategyreview/2015/12/17/what-a-Fed-rate-rise-means-for-the-world-economy/#716854ce83a0