How Do Fed Rate Hikes Affect The U.S. And Global Economies?

The uncertainty of whether or not the Federal Reserve will raise interest rates has set global markets on edge for most of the past year. With a December hike looming—one that will move the current rate away from its current zero percent and will be the first increase since 2008–more and more central banks have put their own activity on hold in anticipation of a Fed decision.

What is the significance of an interest rate hike and why is the Fed move so pivotal at the moment?

The Federal Reserve Bank is the central bank of the United States. One of its major functions is to control monetary policy and it does this by increasing interest rates when the economy is growing too fast. This encourages people to save more and spend less, strengthening the dollar and reducing inflationary pressure. Conversely, when the economy is in a recession or growing too slowly, the Fed reduces interest rates to stimulate spending, which increases inflation.

WITH A DECEMBER HIKE LOOMING… MORE AND MORE CENTRAL BANKS HAVE PUT THEIR OWN ACTIVITY ON HOLD IN ANTICIPATION OF A FED DECISION.

Inflation Control

The Fed uses its control of monetary policy by setting a specific inflation rate which it believes will maintain stable consumer spending and the correct level of employment. When the economy is weak, inflation naturally falls; when the economy is strong, rising wages increase inflation. In 2011, the Fed officially adopted a 2% growth rate in order to help the economy grow at a healthy rate.

When the Fed introduced a near zero interest rate during the financial crisis in 2007, it expected inflation to increase steadily over the years. However, this failed to happen and now in 2015, inflation is still well below the 2% target, which is contrary to the normal effects of low interest rates. The reasons cited for low inflation in a low interest environment are falling oil prices and global economic crises.

A low interest rate helps businesses to expand, which in turn leads to more jobs and greater consumption. Under normal economic conditions, increases in the federal funds rate reduce inflation and increase the appreciation of the U.S. dollar. In addition, when the Fed increases interest rates, it attracts foreign funds to the U.S. which leads to a natural appreciation of the U.S. dollar, despite stagnant wages and low domestic consumption.