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The Federal Reserve spinning the wheels of interest rates

To which extent interest rates will rise? How quickly will the Fed react?
The Federal Reserve spinning the wheels of interest rates
US Federal Reserve

It has been confirmed that the Federal Reserve‘s Open Market Committee will announce at its next meeting on March 15 and 16 an increase in interest rates on federal funds.

Those rates determine the cost of funds that banks lend to each other.

In fact, the question about the possibility of a jump in basic interest rates is behind us. The Federal Open Market Committee paved the way for this measure by declaring its readiness to increase it.

The purpose of this step is to tame inflation rates that prices of goods recorded at the end of last year, rising at the fastest pace since 1982.

The expected high borrowing costs will help in combating inflation by lowering demand for goods.

At the end of last year, prices of goods in the United States witnessed a substantial increase of 7.1%.

In parallel, the latest data indicated a rise in the personal consumption expenditures index last year, which grew at the fastest pace since 1982, reaching 5.8%. The Federal Reserve considers this index as the most accurate measure of inflation.

Today, the question remains: to which extent interest rates will rise, and how quickly will the Federal Reserve react? This is relevant as the Federal Reserve may increase interest rates up to 6 times this year.

Pumping liquidity: Problems and solutions

 

Nassib Ghobril, Chief Economist at Byblos Bank,  told Middle East Economy: “The previous goal of the Federal Reserve’s decision to lower interest rates, which was followed by global central banks, was to face the consequences of the Coronavirus pandemic, and spur economic activity, in support of the private sector as well as individuals.”

“Additionally, this measure was accompanied by monetary and financial measures such as increased spending and tax exemptions.”

The introduction of COVID vaccines, lessening of precautionary measures, relaunching of economic drivers, and the US economic recovery, all necessitated talks about increasing interest rates, Ghobril added.

The latter was due to the high levels of liquidity pumped into the markets, coupled with the rise in global oil prices.

Critical steps leading to FED’s decision

 

At the meeting of the Federal Open Market Committee on January 26, investors expected an immediate increase in the federal fund’s interest rates, for the aforementioned reasons.

However, Jerome Powell, Chairman of the Federal Reserve, sought to reassure both markets and investors.

Alternatively, the committee headed by Powell, who is seeking a new term, announced readiness to elevate basic interest rates at its upcoming meeting, in order to counter inflation.

In March 2020, interest rates hovered around 0% and 0.25%, as part of measures taken to tackle the effects of the Coronavirus pandemic. In addition, it announced that the date for the termination of the bond-buying program would be postponed till June instead of March 2022.

The committee’s decision was also devoid of any signs that the central bank was ready to take tougher measures than expected to tackle inflation. “It will soon be appropriate to raise the target range for the federal funds rate as inflation is well above 2% and the labor market is strong,” it said in a statement.

While Powell strongly hinted that the Fed is ready to raise interest rates at its next meeting: “I think the committee is considering raising the fed funds rates at the March should the conditions be right.”

The dollar: the biggest winner.. the stock market: the victim

 

It was natural that the dollar was the winner, as interest rate hikes usually lead to the rise of the dollar against other major currencies.

Nevertheless, stock markets will be the victim. While a change in an interest rate usually takes at least 12 months to have a broad economic impact, the stock market’s response to a change is often more immediate.

It’s because higher interest rates make other investments more attractive, apart from negatively impacting earnings and stock prices (except for the financial sector).

As a matter of fact,  federal fund rates are the main influencers on the stock markets (the interest that depository institutions—banks, savings, and credit unions — charge each other for overnight loans).

To simplify further, when the Federal Reserve increases the federal funds rate, it is effectively trying to reduce the supply of money available for purchase. However, that, in turn, makes it more expensive to get funds.

The yield on US Treasuries rose

 

Fadi Kanso, Head of Research at Arab Federation of Capital Markets, explained to Economy Middle East that, in addition to the above, the yield on US 10-year treasury bonds jumped to 1.86%, following the Fed’s stance, and this for the first time in more than 3 years.

Nonetheless, the U.S. Treasury yields recently fell as investors digested a stronger-than-expected GDP report.

The US Department of Commerce issued a report signaling that the US gross domestic product grew by 6.9% in Q4, 2021, despite the prevalence of the Omicron variant.

The 10-year U.S. Treasury yield dipped recently after the Federal Reserve’s key inflation gauge rose at its fastest clip since December 1983.

US Dollar

The impact of the “federal” decision on the Arab world

 

Will Arab and Gulf central banks follow the Federal Reserve’s expected measure? What is the impact on their countries’ economies?

Ghobril believes that Arab and Gulf central banks, which link their countries’ currencies to the dollar, will raise interest rates in an effort to maintain their currency stability.

He also expected that large capital flows towards emerging markets will decline, which amounted to $1,100 billion in 2020 and $1,500 billion in 2021.

That’s when they benefited from higher interest rates in these markets compared to the interest-based on US Treasury bonds.

This suggests that we will witness a slowdown in the influx of these flows towards emerging markets alongside their exit at a later stage. It’s due to the increasing pace of US interest rate increases, which will make US Treasury bonds more attractive.

On a parallel line, Ghobril discusses the expected rise in the cost of borrowing from global markets. This will aggravate the situation of emerging countries that are already suffering from financial imbalances.

The imbalances are a result of heavy spending during COVID-19, and low revenues compared to GDP, which led to budget deficits.

On the other hand, the International Monetary Fund warned months ago that raising interest rates too quickly could penalize emerging and developing countries. These countries’ debt is defined in dollars.

Among the repercussions is also the growing current account deficit, which will worsen with the rise in oil prices.

It’s because importing countries will need to transfer larger amounts for imports, according to Ghobril.