The FED Reserve Board sets a benchmark interest rate that commercial banks use as a yardstick to set their lending and borrowing rates.
What is the FED Rate?
FED rate is the benchmark interest rate at which these institutions exchange funds with each other. The FED rate then becomes the base or yardstick to set other important interest rates like the Prime Rate.
The Federal Open Market Committee (FOMC) has a target interest rate that acts as a benchmark for all types of financial institutions in the US.
What is the FED interest rate hike?
With an interest rate hike, the FED aims to shrink economic activity by decreasing credit supply. The FED usually raises its Fund Rate to control inflation and the credit supply in the country.
Conversely, the FED lowers the Fund Rate to boost economic activities as it did (to 0%) in 2008 after the global financial crisis.
Since the FED Fund Rate is the yardstick to other interest rates in the US, it is a pivotal tool for the Federal Reserve Board to control the credit supply in the country.
The prime task of the Fed Reserve is to control prices in the US economy. Therefore, when it adjusts its target Fund Rate, it tries to adjust the economy as they aim.
How Does the FED Rate Hikes Impact Consumers?
Any changes to the FED Fund Rate have a direct impact on a consumer or investor.
Edward Kendy, a forex broker expert at Bestonlineforexbroker.com™ describes a few major ways how the FED’s consistent rate hikes have a significant impact on retail investors and common people.
Borrowing Costs Rise
As soon as the FED raises its benchmark rate, the prime rate goes up. By formula, it’s directly proportional to the FED Fund Rate (Prime Rate = FED rate + 3%).
What does it mean for you?
Borrowing costs rise as banks and lenders charge a higher interest rate. Put simply, your credit card becomes even more expensive.
Economic Activities Slow Down
The FED aims to keep inflation under check by raising interest rates. It means the lending costs rise for banks and there is less credit supply in the market.
However, if the FED’s interest rates rise excessively, it results in an economic recession as the consumers have expensive credit which results in lower spending.
Mortgage and Housing Sectors Face a Slump
Mortgage rates usually fluctuate the way the FED rate moves. It means with rising interest rates, the mortgage rates increase too.
It may result in a short-term increased activity as home buyers look to close deals with existing rates quickly. However, the housing sector slows down due to expensive mortgage deals in the long term.
Saving Yields Go Up
Finally, some good news for you. The saving rates rise with the rising interest rates too. It’s an opportunity for you to offset some part of the expensive borrowing costs.
It means you can enjoy higher saving yields through High-Yield saving accounts, Certificates of Deposit (CDs), and other instruments.
What Happens to the Investor Market with a Fed Rate Hike?
If the FED Fund Rate keeps rising for a long and it does stay high, the stock market eventually goes into a slump too.
It happens because rising borrowing costs mean less cash supply for businesses. The economy goes into a recession and investors pull out their investments.
A slowing economy and rising borrowing costs mean lower profits for private and public companies. It has a direct impact on the stocks in the short term as prices fall.
However, the impact of a sluggish economy isn’t even for all types of stocks. Some sectors fare well in recessions too like consumer staples, the health sector, energy stocks, and Tech stocks.
The current series of rate hikes from the FED couldn’t contain giant tech stocks from sharp gains in Q1 of 2023.
Existing bonds lose value when interest rates rise in the market. Investors invest money in new bonds offering higher yields.
It means your existing bond investments would go for a discount and newer investments will yield higher returns.
Indices and Funds
All major indices like the NASDAQ, S&P500, and the DJIA have shown positive gains historically whenever the FED Fund Rate had gone up.
A research report shows that the median gain on NASDAQ, S&P 500, and DJIA increased by 26.9%, 30.0%, and 17.4% respectively during the last five interest rate hikes.
Thus, if you want to invest in the funds and indices, keep your faith for longer as these instruments show significant returns in the long term after rate hikes.
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