Today, we are going to be discussing the recent US Federal Reserve (Fed) announcement that indicated there could be interest rate hikes as soon as 2022, after signalling in March that it saw no increases until beyond 2023. The Fed also revised the expected inflation rate for 2021 upwards, from 2.2% to 3.4%
The US Fed is the central bank of America.
Why has the Fed decided to increase interest rates?
The simple answer to this question is that the economic recovery in the US has been going well since the American government injected nearly $3 trillion in fiscal stimulus to boost the economy following the COVID-19 pandemic.
The US has been adding more jobs but the increased prosperity has led to increased demand, which has not yet been matched by an increased supply due to ‘supply bottlenecks and hiring difficulties’ faced by firms. It has been widely reported that some businesses are struggling to fill vacancies due to some workers preferring to remain unemployed, given that they earn more from the stimulus cheques than from their previous jobs.
The worry for the Fed is that the inflation could be higher and more persistent than they expected. Consequently, they plan on increasing the interest rate to tackle inflation.
As we’ve previously discussed, high inflation can be curtailed by increasing the interest rate. High interest would make government securities, such as bonds, to be more attractive and cause a switch from spending towards investments, thereby easing inflationary pressures.
How did the markets react?
US stocks opened lower last Friday and ended the week on a negative note as investors continued to digest the change in tone by the Federal Reserve. The Dow Jones Industrial Average (DJIA) lost 3.45% marking its worst week since October last year. The S&P 500 was down by 1.91%. The Nasdaq composite — which comprises largely tech stocks — was down by 0.28%.
Why did the markets react this way?
Low interest rates are beneficial for stocks because they become more attractive investment options relative to bonds and other fixed-income assets. Consequently, the news that the Fed plans on increasing the interest rates sooner than expected caused some investors to reduce their investments in stocks and move towards fixed income securities.