26 April 2023 | ZebPay Trade-Desk
In recent years, the Federal Reserve has been at the forefront of economic headlines. After the economic problems caused by the pandemic were tackled with aggressive quantitative easing, interest rate hikes are now being introduced to combat high inflation. Let’s understand how Federal Reserve rate hikes affect the crypto market.
What does the Federal Reserve do?
The Fed or Federal Reserve is the institution responsible for maintaining the US economy. As the central bank of the United States, it has three main objectives.
- High employment rate
- Stable prices ( low and stable inflation rate)
- Moderate interest rates in the US economy
High Employment Rate: The Fed strives to create the highest level of sustainable employment, taking into account factors such as job growth, labor force participation and the unemployment rate. By tightening monetary policy, the Fed can foster an economic environment conducive to job creation and stability in the labor market.
Stable Prices: Keeping inflation under control is critical to promoting economic security, maintaining the real value of money, and promoting long-term economic growth. The Federal Reserve targets an inflation rate of 2% over time as part of its price stability mandate.
Moderate long-term interest rates: Maintaining moderate long-term interest rates can lead to sustained economic growth and investment. By influencing short-term interest rates, e.g. the Federal Funds Rate, the Federal Reserve can indirectly influence long-term interest rates and contribute to a stable and healthy financial environment.
In other words, the Federal Reserve must create an environment where prices are stable and new jobs can be created. To this end, it monitors the risks of the economy and frequently makes changes in monetary policy.
Monetary Policy explained
Monetary policy is the collection of rules established by a country’s central bank to govern the flow of money to the economy and fulfil the previously mentioned key goals (maximum employment, low and stable inflation, and moderate interest rates). Monetary policy can be changed by central banks to combat inflation and rising prices, create new jobs, or soften the consequences of a recession. Monetary policy can thus be viewed as a toolbox that central banks might use to drive the economy in the desired direction. The most well-known monetary policy tools include quantitative easing, open market operations, interest rate changes, and reserve requirements, but central banks can use many more.
The Federal Open Market Committee (FOMC) meets eight times a year at the very least. If necessary, the FOMC may convene additional emergency meetings. This occurred most recently following the banking crisis that affected two major US institutions. At meetings, FOMC members assess the status of the economy and potential threats, and debate whether monetary policy should be altered. Following the epidemic, the Federal Reserve injected enormous amounts of capital into the economy. While this addressed immediate issues, it had the following detrimental consequences: Inflation accelerated, reaching 9.1% year on year in June 2022. Since then, the FOMC has attempted to reduce inflation by raising interest rates, which might harm employment and produce an economic recession. As you can see, the FOMC’s job is not easy.
Coming back to the rate increases. A rate hike refers to an increase in the federal funds rate, which is the rate at which commercial banks can borrow and lend money overnight. The Federal Funds Rate is a set of interest rates at which banks can borrow or lend money. With inflation out of control, the FOMC agreed to hike interest rates nine times in a year, from 0.25% to 5%. When the federal funds rate rises, so does the cost of capital. It raises the cost of borrowing for banks, causing them to offer higher interest rates to their clients. Mortgages are becoming more expensive, as are company borrowing expenses and credit card surcharges. In other words, by rising interest rates, the Federal Reserve increases the cost of investing or spending money, decreasing the demand curve. We know from economics that a decrease in demand usually results in cheaper prices. Raising interest rates to lower prices (and thus inflation) is like deploying a fire extinguisher!
Read more: Inflationary vs Deflationary Crypto
Impact of interest rates on Financial Markets
In addition to fighting inflation, the change in the Federal Funds Rate is having an impact on the economy and even on financial markets. The change in the Federal Funds Rate is a constant concern in the stock market. For example, stock markets will rise when the Federal Reserve cuts interest rates because falling costs of doing business cause profits to increase for publicly traded companies. On the other hand, a rise in interest rates generally leads stock prices to decline because it results in increased business costs and reduces profits. Due to the correlation between stock markets and crypto assets, a bearish reaction in the stock market will also cause your token prices to drop.
The markets are very good at pricing information and often move in anticipation of FOMC decisions. The market surged on March 22nd, anticipating a pause in the rise of interest rates. There was a 7.9% drop in the price of Bitcoin after the Fed raised its latest rate by 25 basis points.
The 25 basis point increase announcement at the beginning of this tightening cycle had come as a surprise and it triggered an immediate selloff. The impact of the new rate increase decisions appears to have subsided slightly since we’ve had nine consecutive increases in rates. While volatility remains a reasonably high level, the market is fairly well behaved in tracking corrections and returning to levels that it was at prior to the rate increase announcement.
However, there is no doubt that the Fed exercises a strong influence on financial markets. The quantitative easing programme has pushed asset prices to all time highs in 2021 and the decision to increase interest rates over the last year has contributed to a fall in prices. The market is more and more accustomed to increases in interest rates by then, with their short term price effects fading. Interest rate decisions are hard to predict, and it is even more difficult to anticipate their impact on the market.