The Effects of the Fed’s Interest Rate Hike
Over the last several months, the Federal Reserve has raised interest rates to their highest levels since the 1980s. The reason? Inflation. (Inflation, by the way, is simply when prices rise.) A small amount of inflation from year to year is not a big deal — the Fed actually targets a 2% annual inflation rate — but this past June, inflation peaked at 9%, the highest it has been since 1981. It has since fallen to 6%, still well above the preferred rate. High inflation can be very detrimental for the average person: the cost of living increases, which means people have less discretionary income and less money to save for retirement. So, it seems that the Fed is quite justified in its attempts to curb inflation. But as we’ll see, it’s not so simple — high interest rates can also cause significant stress to our financial system.
First, let’s take a closer look at the inflation we're facing today. It likely has its roots in two of the major global events of the last few years — the COVID 19 pandemic and the Russia-Ukraine conflict. The pandemic caused worker shortages and supply chain issues, which raised companies' costs of producing goods. Companies then passed those costs on to customers in the form of higher prices. Additionally, significant government stimulus during the pandemic gave consumers extra money to spend. Then, last year, the Russia-Ukraine conflict caused food and energy prices worldwide to skyrocket, adding to already high inflation.
So, as we mentioned above, the Fed’s primary tool to maintain inflation is to raise interest rates. But what do interest rates have to do with inflation? Well, interest rates can be thought of as the cost of borrowing money — so if the interest rate is 2%, my “cost” for borrowing $100 would be $2, leading to a $102 payment at the end of my loan. So, a higher cost of borrowing means both businesses and consumers borrow less money; therefore, businesses are forced to scale back on new projects and investments, leading to slower GDP growth, as we saw last year. In this sense, interest rates are thought of as a way to “cool down” the economy and control prices. Additionally, consumers borrow less and therefore have less money to spend on products, which decreases demand and forces companies to lower prices.
So, it seems like raising rates is the correct course of action for the Fed, especially in our current economic environment. However, high interest rates can have a variety of other consequences, both expected and unexpected: first, high interest rates cause the stock market to fall, as companies’ future earnings are discounted at a higher rate. If that doesn’t make too much sense, here’s a great video that explains this concept on a technical level. It’s no coincidence that last year, when the Fed began raising rates at historically high levels, the S&P 500 index was down 19.4%.
But, over the last couple of weeks, we have seen far worse, unanticipated consequences of high interest rates: namely, the failures of Silicon Valley Bank (SVB) and Signature Bank, which were the second and third largest bank failures in American history. Now, how did high interest rates cause these banks to fail? First, a little background is necessary: when banks receive deposits from customers, they typically lend that money to borrowers or invest it in government bonds and other low-risk securities. This is how banks can promise to give depositors more than they originally deposited. And here’s the last finance lesson for today - when interest rates rise, bond prices fall. Now, SVB invested tens of billions of dollars in long-term US treasuries. When the Fed began rapidly raising rates, SVB suffered massive losses. When customers found out, they panicked and began withdrawing funds. Withdrawal requests reached $42 billion, and SVB ultimately did not have enough cash to fulfill all deposit requests. Finally, on March 10th, SVB was closed down by regulators. But the damage didn’t stop there. After SVB’s failure, panic among depositors spread, leading to the collapse of Signature Bank, and forcing Credit Suisse, Switzerland’s second-largest bank, to take a $53 billion loan from the Swiss central bank to assure investors of their financial stability. Ultimately, however, it was too little, too late for Credit Suisse, as they recently reached a deal to be acquired by UBS, marking the end of a 167-year run. Just like that, in a span of two weeks, three banks have collapsed, and many are questioning the health of our global financial system. So, we have seen that far from being a perfect solution, high interest rates can also be quite harmful.
On Wednesday, March 23, just days after the above-mentioned crises, Fed Chair Jerome Powell announced that the Fed would be raising rates again, this time a quarter-percentage point. He also implied that the Fed would most likely end their rate hike sooner than previously anticipated, undoubtedly due to the recent banking crisis it has caused. Now, this was surely an incredibly difficult decision to make. Many expected the Fed to refrain from raising rates given the stress it has caused to the financial markets. On the other hand, inflation is still high, and raising rates is the most effective way to curb inflation. Only time will tell if Powell made the right choice.
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Photo Caption: Higher Interest Rates Ahead Sign
Photo Credit: Pixabay