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Why are US interest rate hikes highly vital for the world economy?

Why are US interest rate hikes highly vital for the world economy? thumbnail

The US revealed its latest big interest rate hike on Wednesday, in the hope that it will tame inflation that’s running hot in the world’s largest economy. While this mirrors a direction most other key economies worldwide are pursuing, the latest move by the US has helped build momentum further.

Interest rates are fundamental indicators of an economy’s growth. In the US, the Federal Reserve’s move to increase interest rates is expected to spur growth and exuberance on the part of investors, while tempering the economy itself.

This is primarily because higher interest rates can help any economy avoid overproduction and asset bubbles fueled by cheap debt.

While the Fed’s primary concern is the US economy, it will also be eyeing the effect its rate increase will have on foreign trade, and on the world’s credit and commodities markets. Because US has the largest economy, every economic move that the US makes has immediate effects on markets worldwide.

US stock markets rate hike
In the US, the Federal Reserve’s move to increase interest rates is expected to spur growth and exuberance on the part of investors, while tempering the economy itself.
Image Credit: Shutterstock

US hikes rates for a fifth time, more to follow

The Fed on Wednesday raised interest rates by another three-quarters of a percentage point to a range of 3 per cent to 3.25 per cent, the highest since early 2008. This was their fifth, and expectedly last, rate hike of this year. However, the fight to combat inflation doesn’t end there.

The Fed is expected to raise interest rates as high as 4.6 per cent in 2023 before the central bank stops its fight against soaring inflation, according to its median forecast released on Wednesday. The median forecast also showed that central bank officials expect to hike rates to 4.4 per cent by the end of 2022.

“At the moment, there’s speculation, worldwide, about whether or not the US is about to raise interest rates further – and with indicators pointing to another rate increase, there are concerns about ripple effects throughout the rest of the world,” said Brody Dunn, an investment manager at a UAE-based asset advisory firm.

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With only two policy meetings left in the calendar year, chances are the central bank could conduct another 75-basis-point rate hike before the year-end. The series of big rate hikes are expected to slow down the economy. The Fed showed GDP growth is forecast to slump to just 0.2 per cent for 2022.

At the moment, there’s speculation, worldwide, about whether or not the US is about to raise interest rates further – with indicators pointing to another rate increase.

– Brody Dunn

How interest rate hikes help bring down inflation

With the aggressive tightening, inflation, measured by the Fed’s preferred personal consumption expenditures price index, is expected to decline to 5.4 per cent this year. The gauge stood at 6.3 per cent in August. Fed officials see inflation eventually fall back to the Fed’s 2 per cent goal by 2025.

The Fed’s top tool for controlling inflation is its power to affect interest rates. The Fed can raise or lower the rate at which federal funds rare released into the economy, based on the requirement. The rate influences how much banks pay to borrow, and ripples down to businesses and households from there.

Low rates help juice the economy by making it cheaper for businesses and households to invest in new projects, hire staff or take out a loan to buy expensive items like homes or cars. Higher rates do the opposite, and are designed to slow the economy by dampening consumer demand.

Inflation happens when there’s a mismatch of supply and demand in the economy. During the pandemic, for example, many wanted to buy cars that factories couldn’t keep up. Families downgraded to more budget-friendly houses, but there weren’t enough available. So cars and houses got pricier.

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While the rise in the cost of living is a sign that an economy is growing, if the economy grows too fast, prices rise faster than wages, then the government will be forced to raise interest rates. This discourages borrowing and encourages saving, which tends to slow the economy down – and decrease inflation.

Interest rate inflation
The central bank’s top tool for controlling inflation is its power to affect interest rates. While the rise in the cost of living is a sign that an economy is growing, if the economy grows too fast, prices rise faster than wages, then the government will be forced to raise interest rates.
Image Credit: Shutterstock

Why do US interest rates move the global economy?

Following the financial crisis of 2008, the Fed implemented years of monetary easing to stimulate economic recovery, slashing rates to a near-zero, where they remained for the next six years. And history repeated itself with the health crisis brought on by the COVID-19 pandemic.

The reasoning behind this is simple. It’s simply to spur investments, along with consumer spending, and drag the economy out of recession. In the years that followed, the economy did begun to recover, and, as a result, the Fed has indicated that it will raise interest rates once again.

“Historically, rising interest rates have gone hand-in-hand with an appreciating US dollar, and as a result several other currencies that are linked to the greenback,” added Dunn. “This, in turn, affects economic facets domestically and around the world – the credit market, commodities, stocks, and investments.”

“And in many parts of the world, the US dollar is used as a benchmark of current and future economic growth. In developed countries, a strong dollar is seen in a positive light. However, for emerging economies the co-relation isn’t as straight-forward.”

Historically, rising interest rates have gone hand-in-hand with an appreciating US dollar, and as a result several other currencies that are linked to the greenback

– Brody Dunn

How US interest rates affect credit, commodities and trade

The fear of rising interest rates and the resultant contraction of credit and money supply can be attributed to how higher interest rates lead to a decrease in the money supply and appreciation of the US dollar. At the same time, lending and credit markets contract.

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As interest rates increase, the cost of credit does, too. From bank loans to mortgages, it becomes more expensive to borrow. Hence, an increase in the cost of capital can hinder consumption, manufacturing, and production.

Oil, gold, cotton and other global commodities are priced in US dollars, and a strong currency following a rate increase would increase the price of commodities for non-dollar holders. Economies that rely primarily on commodity production and an abundance of natural resources will be worse off. As the products of their principle industrial decline in value, their available credit streams will shrink.

Despite the ways in which US interest rates negatively impact the global economy, rising interest rates do benefit foreign trade. The stronger dollar that will accompany the rate increase should boost US demand for products around the world, increasing corporate profits for domestic and foreign companies alike. Because fluctuations in the stock market reflect beliefs about whether industries grow or contract, the resulting profit spikes will lead to stock market will rallies.

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