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Understanding the impacts of US Fed rate changes
When interest rates are high, people tend to save rather than spend money, causing inflation to decrease, but falling consumption can also cause the economy to slow down.
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The United States Federal Reserve building is pictured on March 18, 2008, in Washington, DC. (Reuters/Jason Reed)
T
he worldwide central bank interest rate increases are a noteworthy concern for financial market players. Moreover, it is difficult to get inflation under control in some developed countries and so high-interest rate policies will probably be maintained. As a result of rising prices, which create higher inflation, interest rate policy measures are increasingly being scrutinized. Interest rate policy is one of the monetary policy tools used to achieve a central bank’s target. The United States federal funds rate (FFR) increase has attracted market attention recently as it aimed to reduce inflationary pressure from the economy. The US Federal Reserve considers several factors in deciding the interest rate, including economic growth, inflation rates, labor market developments and financial market stability.
Currently, the US economy remains strong; with continued increases in investment, public consumption remains high and is accompanied by a decline in the unemployment rate. Thus, it is likely that the Fed will further increase interest rates to lower the inflation pressure. Furthermore, US inflation is still higher than the Fed's long-term target of 2 percent, and so FFR increases will most likely continue.
In the global banking sector, the Fed's interest rate increase can significantly impact various business activities. First, an increase in the reference interest rate can cause increased borrowing costs for customers, thereby reducing customers' interest in taking out new loans or extending existing loans. Second, an interest rate increase can impact income from products and services banks offer. For example, rising interest rates can cause a decrease in interest earned on banking products such as savings or deposits.
Therefore, changes in interest rate policy are always a concern for the market, including this year, with projections that the Fed will continue to implement its tight monetary policy by raising interest rates or maintaining interest rates at a high position for longer. Interest rate hikes to reduce inflation can also weaken economic growth.
When interest rates are high, people tend to save rather than spend money, causing inflation to decrease, but falling consumption can also cause the economy to slow down.
The policies taken by the Fed can affect global financial markets.
Apart from impacting the banking sector and economic growth, the Fed's policies influence investors' risk appetites in the financial markets. The policies taken by the Fed can affect global financial markets because the US is one of the world’s largest economies. The Fed's FFR increases or decreases influence interest rate movements in global markets. An increase in the FFR can encourage foreign investors to withdraw their investments from countries with lower interest rates, thereby causing currency weakness and pressure on financial markets in these countries. Furthermore, the Fed's policies can also influence the performance of the global stock market. When the Fed carries policies favorable to investors or traders, such as lowering interest rates or providing economic stimulus, the global stock market will experience an upward trend because investors become more optimistic. Conversely, policies perceived as unfavorable by the market, such as rapidly raising interest rates, can cause a decline in global stock markets.
This year, the Fed has increased the FFR as US economic growth continues to strengthen, and inflation remains above target. The Fed will strive to reduce inflation toward its long-term target of around 2 percent by monitoring and adjusting policy according to future economic conditions. The Fed is also paying attention to the shape of the labor market, which is still quite solid. If there is a significant increase in job creation, the Fed will likely take action to reduce monetary stimulus.
At last week's September 2023 Federal Open Market Committee (FOMC) meeting, the Fed maintained its benchmark interest rate in the 5.25 percent - 5.5 percent range, the highest in the last 22 years. This decision aligns with US economic growth and the intense labor sector, with inflationary pressures that will still be difficult to reduce. Economic growth and the labor sector will continue to improve with a relatively low unemployment rate like the current rate of 3.8 percent as of August 2023. Even though the Fed's decision is in line with market expectations, the Fed has indicated that it might increase the Fed Funds benchmark interest rate toward the end of 2023. This decision has caused global financial markets to become more volatile.
In the money market, the US dollar index remained at a high level. The US dollar index rose above 105.5, the highest since early March 2023, after the Fed signaled that there was still room for interest rate increases in the future. The movement of the US dollar, which tends to strengthen against major currencies, is also reflected in the weakening of several major currencies. The Yen weakened to below 148 per US dollar, its lowest level since early November 2023, as the Bank of Japan is also expected to keep its main short-term interest rate at -0.1 percent. In addition, the Euro fell by 0.2 percent following the European Central Bank's (ECB) decision to increase the ECB benchmark interest rate by 25 basis points (bps) to 4.5 percent because of Europe's still high inflation.
The Pound sterling also fell to 1.227 per US dollar, its lowest level since March 2023, after the Bank of England decided to keep interest rates unchanged. Interestingly, although most of the Asian currencies were corrected, they managed to continue strengthening because they were supported by the domestic fundamentals of each country, which were still solid, and the policies adopted by the central banks of each country to maintain exchange rate stability.
Regarding Indonesia, the Fed's decision also influences the money and domestic capital markets. The Rupiah moved sideways in the range of 15,350 - 15,450 after the Fed's decision. The stock market experienced a correction, while the domestic bond market was depressed with the increase in yields on all benchmark government bond tenors. Throughout September 2023, the foreign funds' outflow from the domestic capital market was recorded at around Rp 11.5 trillion (US$744 billion) in the stock and bond market. Market concerns regarding the risks of an increase in the FFR are still open, so volatility in financial markets remains high in the short term. However, the Rupiah can still strengthen in the future, supported by solid economic fundamental policies and global interest rate policies that have been priced in, so market volatility is expected to decrease. With the Rupiah expected to strengthen, we also see a tendency for benchmark bond yields to decline from their current levels.
The weakening of the Rupiah, which was not as deep as the depreciation of some other Southeast Asian currencies, was influenced by domestic economic fundamentals, which remained strong amid global uncertainty and Bank Indonesia's (BI) policy to support rupiah stability. BI continues to implement the triple intervention policy, twist operation, as well as the DHE (export proceeds) and new instruments such as Bank Indonesia Rupiah Securities (SRBI) to support financial market deepening and encourage the inflow of foreign funds into the domestic market to reduce market pressures.
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The writer is a senior quantitative analyst at Bank Mandiri.
