🔹 The Federal Reserve hiked the Federal funds rate five times, so far, in 2022.
🔹 The 0.5% Federal Fund Rate hike in May 2022 was one reason for the lengthy crypto winter.
🔹 High interest rates create panic in the crypto market resulting in mass sell-offs.
🔹 Federal funds rate hikes can cause some cryptocurrencies to collapse.
, invented just after the peak of the 2007 and 2008 global financial crisis, existed for a long period when interest rates were ultra-low. Therefore, the world cannot quantify the effects of the rise in interest rate on cryptocurrencies since 2022 is the first year with continual increase in interest rate in the United States.
The Federal Funds rate
As we focus on the possible effects of a hike in the Federal Funds rate we need to understand what interest rate is. Primarily, interest rate is the cost of borrowing funds. It is a charge a lender adds to the borrower’s principal amount as an opportunity cost for parting with his/her money. In an economy, the interest rate is set as a percentage of the principal amount.
On the other hand, the Federal funds rate refers to the interest rate which the United States government charges on depository institutions such as banks and other lending entities. It is a component of the government’s monetary policy used to curb inflation and address other economic vices. The Federal funds rate decreases the country’s money supply, thereby reducing inflationary pressures.
Many monetary institutions, in turn, use the Federal funds rate to peg their own lending interest rates like percentage rates (APRs) and mortgage loan rates.
Why the Federal Fund Rate is Significant
During the greater part of this year, 2022, the increases in the Federal funds rate heavily impacted the crypto sector as well as the stock market. The main reason why the hikes in federal funds rate affect the total crypto market is that the United States has the largest number of cryptocurrency users based on national comparisons. Therefore, the crypto investment activities of the United States residents affect the global price of cryptocurrencies.
Changes in Federal rates in United States
CNET reports that the current Federal Funds rate is between 2.25% and 2.5%. However, it estimates that if the inflation rate in the United States continues to increase during the year, the Federal funds rate could range between 3.5% and 4% by the end of 2022.
The greatest interest rate hike in 2022, so far, was the 0.5% increase in May. Incidentally, this was the highest rate within the past 20 years. On average, however, the inflation rate has been increasing since the first quarter of 2022. While the inflation rate in May was 8.6%, it shot up to 9.1% in June. Although there was a decrease in the year-to-year inflation from July to August, the month-on-month rate increased by 1.0%.
It is important to note that the year-to-year inflation for August was 8.3%, indicating that the inflationary pressure is still very high. Overall, the prices of most goods and services in the United States increased in August. This general rise in prices of key products indicates that the Federal Reserve is likely to increase the Federal fund rate by at least 75 points.
During a press conference
in July, the United States Secretary of State, Powell said, "We are highly attentive to inflation risks and determined to take the measures necessary to return inflation to our 2% longer run goal.”
Why the Federal Reserve Hikes the Federal Fund Rate
The aim of the Federal Reserve in raising interest is to abate the soaring inflation rate. High interest results in less consumer purchasing power which can dampen the country’s economic growth, thereby slowing the inflation rate. For example, inflation erodes wages of the workers since salary adjustments are not aligned to the inflation rate.
In addition, high inflation rate results in an increase in the level of unemployment, tumbling of prices of stocks and other investment instruments. This is the reason for the Federal Reserve to have the sixth Federal funds rate hike.
Therefore, by increasing the federal fund rate the United States makes borrowing expensive, reducing the demand for money. This forces businesses to reduce their investment which balances supply and demand of goods and services in the economy. Above this,it helps to maintain price stability in the country.
How high interest rate affects the crypto market
Any changes in macroeconomic fundamentals, such as interest rates or inflation rate, affect investments in one way or the other. They can affect the cryptocurrency sector in the same ways as they do in the traditional finance market.
Reduction in crypto investments
When the government raises interest rates investors reduce their investments in high risk portfolios including cryptocurrencies. It is beyond doubt that cryptocurrencies are risk investment assets since their prices are highly volatile. Instead, investors would choose to invest in low risk investments. For example, they may choose to put their funds in traditional saving accounts.
High crypto sell-off pressure
Interest rate hikes have led to high crypto selling pressures since the beginning of 2022. This is because high interest results in less free funds to invest in cryptocurrencies. First, when inflation and interest rates are high, people sell-off their cryptocurrencies in order to raise funds to purchase basic goods and services.
As a result, the high selling pressure of cryptocurrencies forces their prices down. This is one explanation for the prolonged crypto winter this year, 2022. Also, investors cannot bid for cryptocurrencies such as BTC and ETH when they lack funds to meet their basic needs.
Crashing of cryptocurrencies
The combined effect of high inflation and interest is dangerous to the crypto sector as it leads to crashing of certain cryptocurrencies. Already, we witnessed what occured this year , several cryptocurrencies collapsed. Indirectly, the collapse of LUNA and UST is a result of an unconducive macro-economic environment, mainly high interest.
Specifically, high interest reduced liquidity in the crypto sector which affected individual cryptocurrencies such as UST and LUNA. In this instance, there was a high sell-off of USD resulting in its depeg. The situation could have been different had the interest and inflation been low.
Does the market stay depressed for long?
Some crypto analysts believe that the impact of an interest rate hike is only for a short period. They say that once the panic of the hike decreases the market will go back to normal. The rate of interest also determines its effect in the crypto market. The 0.5% instituted in May 2022 was too high. That is why its effects spread across the crypto and stock markets for a long period. A lower interest rate would have a less destructive impact on the crypto market.
Many analysts believe that the Federal Reserve is going to increase the Federal funds rate by 75 points. The reason for this assumption is that inflation has not slowed down as expected. Unfortunately, a further rise in interest rate can lead to a more depressed crypto market as some investors may sell-off their holdings to meet their daily needs.
Author: Mashell C.
, Gate.io Researcher
This article represents only the views of the researcher and does not constitute any investment suggestions.
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