The sudden increase in American interest rates

By I. Toledo

After inflation in the USA hit a 4-decade high in the span of 12 months this June, consumer prices marking a 9.1% increase from the year before, the Federal Reserve (Fed) has activated damage control. As a means of cooling down the hottest inflation in 40 years, the country’s central bank is increasing interest rates continuously, having hiked the rate 6 times this year. Currently, the Fed interest rate is at 3.75 to 4.00%, marking the fourth consecutive time the rate has been hiked. ​

Figure 1 – Graph showing the Federal Reserve Interest Rates in 2022 


Why does the Fed raise interest rates to control inflation? 
 
Hiking interest rates is the Fed’s major tool for lowering inflation. This happens because loans become more expensive for both businesses and consumers and savings become more lucrative due to greater interest payments, thus stimulating people to buy less and instead save their money. This reduces money circulation and cools off the economy whilst also lowering prices, as, with fewer demands for consumer goods, sellers are forced to lower their prices to retain customers. 

​Effects of hiking interest rates 
 
The impacts of the rise of interest rates can be either positive or negative depending on who you are. Some of these effects include: 

• A fall in the stock market 

In general, when interest rates increase, stocks perform poorly. This happens because it becomes more expensive for companies to borrow money and causes consumer numbers to decline, thus resulting in less revenue, more debt, and, consequently, a cheaper stock. When this occurs to many companies, the whole market goes down, and because there is an expectation of less growth from stock price appreciation, investors will cease to buy stocks. However, the financial sector benefits from interest rate hikes as they get more money from loans. 

• Increase in revenue for savings accounts and bank deposits 

Higher interest rates benefit owners of savings and deposit accounts. This happens because the banks raise the annual percentage yields (APYs) for these accounts, thus increasing the profit from these. 

• Bonds become less valuable 

Bonds are investment securities where, in exchange for regular interest payments, an investor loans money to a business or the government for a specific length of time. When the Fed increases rates, the value of bonds decrease as the fixed interest rate of the bond is lower than the new rate. This decreases the demand and the price of the bond. 

• Increase in debt of developing countries 

When issuing debt, many developing countries decide on issuing it in a foreign currency, especially the dollar, as it attracts investors and reduces financial instability. However, when interest rates rise in the US, the Dollar appreciates, consequently increasing the value of dollar-denominated debt, as the exchange rate for local currencies to the Dollar becomes more expensive. This can reach a point where it becomes unmanageable, and the countries can experience capital outflows. 

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