Why is the Fed raising interest rates?



At the December Federal Reserve meeting, members finally realised that the inflation in the economy was no longer transitory an acknowledged that prices were increasing rapidly.To get more news about fxpace, you can visit wikifx.com official website.

So, in order to control inflation in the economy, the Fed signalled that it could raise interest rates soon with a possibility of three rate hikes in 2022.

With the market expecting an increase in Fed interest rates soon, US stock markets tumbled in the early days of 2022. The Dow Jones Index, or DJI, fell from 36,799 to 34,079 (as at 18 Feb 2022) and the NASDAQ index fell from 15,832 to 13,548 (as at 18 Feb 2022).

Many US tech stocks also fell from grace with the likes of Nvidia, Microsoft, Tesla and Apple tumbling around 20-30 percent.Generally, there has been an inverse relationship between the Fed funds rate and the performance of the stock market. An increase in the Fed funds rate typically will result in a fall in the stock market.

This interest rate, also known as the federal funds rate, is the interest rate at which financial institutions borrow and lend their excess reserves to each other overnight. As stated by law, US banks must maintain a percentage of their deposits in an account with the Fed which is known as the required reserve ratio. This is to prevent a bank run from happening. A bank run occurs when many clients withdraw their money from the banks simultaneously, and this may affect the liquidity of the banks.

The required reserve ratio is calculated based on the end-of-day balances in the bank’s account averaged over a two-week reserve maintenance period.

So, if one bank finds that it has more than what is required, it can lend the excess to other banks that expect a shortfall in balances and earn interest from it. This interbank lending interest rate is based on the fed funds rate.
How will an increase in the Fed funds rate affect consumers?

When the Fed raises its interest rates, it also influences the prime lending rates that the banks charge their borrowers. Prime rates are the prevailing interest rates that banks charge their customers who have the best creditworthiness. As the fed rates increase, the prime lending rates move in tandem with the increase. This increase also affects consumers’ interest rates for bank loans, credit card loans and adjustable-rate mortgages.

The reason why there is this ripple effect of interest rates increases is because as the borrowing of excess funds increases, banks incur a higher cost to borrow to maintain the required reserve ratio.

The banks then pass on this increase in costs of borrowing to its consumers. Therefore, the prime lending rates increase. And since the prime lending rate sets the benchmark for interest rates of the loans, customers who did not have the best creditworthiness will face a higher interest rate than the prime lending rate as the banks experience more risk as the creditworthiness of customers drops.Inflation is the rate of increase in prices over a given period of time. Therefore, CPI is used as an indicator of inflation in a particular economy.

CPI is a measure that takes the weighted average of prices of a basket of goods and services which consumers require for their day-to-day life.

In January 2022, the US Consumer Price Index, or CPI, rose to 7.5% which was a 40-year high. This means that the US is facing high inflation as the overall cost of living has been increasing drastically.
Inflation is necessary for economic growth as it helps to increase consumption and consumer demand which eventually increases the GDP of an economy.

The estimated benchmark of inflation for a developed nation is around 2% and is meant to stimulate economic growth. However, anything above this could be damaging to the economy as it could affect the livelihoods of its population.