When prices rise, the central bank typically raises its target rate to cool down the overheating economy and control inflation. Central banks are tasked to maintain certain levels of stability within the financial system – of this he most influential tool is to increase or lower the interest rate.
Any change in interest rate have an effect on the building blocks of macroeconomics, such as consumer spending, borrowing, stock market etc. In March last, when Fed raised its federal funds benchmark rate by 25 basis points, it marked the first time since 2018 and which continued in May, June and July.
The June rate hike by an additional 75 basis points was the largest single such since 1994. Additional hikes after this week could continue in November and December.
An alternate way to avoid higher interest payments is to postpone projects that require heavy external financing. Simultaneously, it pushes people to save and earn higher interest payments. This reduces the supply of money in circulation, which tends to lower inflation and moderate economic activity, thus cooling off the economy.
The spill over of high interest rates impact the stock market, and make the cost of doing business rise. Over time, higher costs and less business mean lower revenue and earnings, potentially impacting their stock values. The opportunity to expand investment in capital goods stalls. More visible is the impact on market psychology and how investors react to the emerging dynamics.
Generally, investors move into more defensive investments. Bonds are equally sensitive to interest rate changes. Another important economic indicator - consumer credit - respond more gradually to interest rate increases. Variable rate loans are particularly sensitive as their charges are based on the federal funds rate.
Another spiralling effect is on higher borrowing cost for emerging market that need external borrowing, already facing stiff increases in energy and food import costs due to the pandemic and the Ukraine war. Not all the Interest rate hikes are going to impact directly and not all corners of THE financial world are going to be affected by the new monetary paradigms. Keeping tabs on changes to monetary policy is an important part of keeping one’s financial life in order.