Explanation of the Federal Reserve's Interest Rate Hike

Introduction

Since last year, the Fed’s interest rate hikes have caused global market turmoil and have become one of the most watched events in the market. The series of risk events that followed, such as the Silicon Valley Bank, have had a significant impact on the market. The cryptocurrency market has also experienced a prolonged bear market. This article will focus on the topic of the Fed’s interest rate hikes, explaining what an interest rate hike is, the reasons for this round of interest rate hikes, the impact of interest rate hikes, and make market predictions related to the current monetary policy of the Fed’s interest rate hikes.

What is an Interest Rate Hike?

The Fed can be understood as the central bank of the United States, and its monetary policy is announced through the Federal Open Market Committee (FOMC) meetings. An interest rate hike, in simple terms, refers to an increase in the federal funds rate, reflecting the Fed’s shift from loose to tight monetary policy. In a complete interest rate hike cycle, the Fed will conduct three specific monetary policy operations: reducing asset purchases, increasing interest rates, and reducing its balance sheet. Reducing asset purchases refers to the gradual reduction of the Fed’s asset purchase program, phasing out quantitative easing policies, and reducing the amount of funds flowing into the market. Increasing interest rates refers to raising the US federal funds rate. Reducing the balance sheet refers to reducing the size of the central bank’s balance sheet, mainly through the sale of government bonds and mortgage-backed securities (MBS) or allowing bonds to mature naturally, thereby reducing its asset size.

The federal funds rate is the core monetary policy tool of the Fed, referring to the interest rate at which banks borrow from each other in the US interbank market. Changes in this rate can sensitively reflect the supply and demand of interbank funds. If this rate increases, the interest rates that banks charge for loans to businesses or individuals will also increase, which can increase deposits, reduce loans, restrain investment and consumption, and alleviate economic overheating. Conversely, if interest rates are lowered, the interest rates at which banks lend will decrease, reducing the cost of borrowing, stimulating corporate and personal loans, and making the overall economy more active.

The Process of Interest Rate Hikes

Since 1990, the Fed has experienced four interest rate hike cycles. We are currently in the 5th round, which began in March 2022 and is the largest in history. The entire process of interest rate hikes is shown in the table below.

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Reasons for Interest Rate Hike

The main reason for this round of significant interest rate hikes is severe inflation. The root cause can be traced back to the outbreak of the COVID-19 infection in early 2020, which had a huge impact on the US and European economies. At that time, the US GDP fell by 5% in the first quarter of 2020, and by 31.4% in the second quarter, resulting in an annual decline of 3.5%, the largest drop since World War II and the first negative value since 2009.

To stimulate the economy and maintain high employment, the Federal Reserve (Fed) significantly reduced interest rates and pushed for a substantial decrease in market rates, approaching zero interest rates. On March 15, 2020, it announced the federal funds rate range to be lowered to 0-0.25%, essentially zero interest rates. At the same time, the Fed purchased bonds through open market operations and expanded the central bank’s asset size, greatly increasing the injection of base currency. This led to a substantial increase in the money supply and a significant increase in the government deficit. The Fed’s balance sheet increased from around $4.1 trillion to $8.9 trillion.

The combination of various policies led to double-digit inflation in certain months. To bring the inflation rate back to the long-term target of 2% (which the Fed has set as the long-term inflation goal), the Fed had to raise interest rates significantly in the short term.

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Impact of Interest Rate Hikes

As the Federal Reserve continues to pursue a policy of interest rate hikes, global financial markets are closely monitoring the changes in policy. The main purpose of the Federal Reserve’s interest rate hikes is to control inflation. After a vigorous round of interest rate hikes in 2022, three main effects have become apparent: First, many countries and regions around the world have followed suit and raised interest rates. In 2022, dozens of central banks globally, including the Federal Reserve, the European Central Bank, the Bank of England, the Reserve Bank of Australia, and the Bank of Canada, took action to raise interest rates. Second, many countries and regions are likely to experience an economic downturn in 2023. Third, the value of the US dollar has been steadily increasing. Since the breakdown of the Bretton Woods system, in each of the Federal Reserve’s past cycles of interest rate hikes, with the stable condition of the US economy, the US dollar exchange rate has risen.

At the same time, the impact on the cryptocurrency market is also complex and diverse, primarily manifested in the following two aspects:

1. Bitcoin Price Volatility

Interest rate hikes cause the US dollar to appreciate, which usually leads to a decrease in the value of other currencies, such as Bitcoin and other cryptocurrencies. This is because Bitcoin and other cryptocurrencies are often tied to the US dollar, and the appreciation of the US dollar leads to a decrease in the price of Bitcoin and other cryptocurrencies. Therefore, in general, before the Federal Reserve’s interest rate hikes, Bitcoin usually experiences an upward trend in price. After the Federal Reserve’s interest rate hikes, the price of Bitcoin usually exhibits a downward trend.

2. Volatility of Cryptocurrency Market Sentiment

Federal Reserve interest rate hikes may affect investor sentiment, thereby influencing the price of Bitcoin and other cryptocurrencies. If market sentiment worsens, investors may shift towards more stable assets, leading to a decline in the price of Bitcoin and other cryptocurrencies.

In the latest November monetary policy meeting, the Federal Reserve announced a pause on interest rate hikes. This is the second consecutive time the Federal Reserve has chosen to pause interest rate hikes, and the market’s expectations for the Federal Reserve’s contact with this round of interest rate hikes have once again increased, even beginning to anticipate interest rate cuts by the Federal Reserve starting in 2024. The current labor market and economic conditions in the United States also support the Federal Reserve’s decision to pause on the path of interest rate hikes. According to the latest data, non-farm payrolls in the United States increased by 150,000 in October, below the estimated 180,000; average hourly earnings increased by 0.2% month-on-month and grew by 4.1% year-on-year, the smallest increase since June 2021. This indicates the market’s expectation that the Federal Reserve has completed this round of interest rate hikes and has increased preparations for a “soft landing” of the US economy.

It can be seen that the Federal Reserve’s interest rate hike cycle is likely already completed. Currently, the peak of the interest rate hikes is around 5%, but high interest rates will still be maintained for a period of time. Federal Reserve Chairman Powell holds a cautious attitude and states that the focus will be on the dual mandate of promoting employment and maintaining inflation stability, and will firmly commit to the 2% inflation target. Looking back at the cryptocurrency market, it has shown signs of bottoming out and rebounding since October. Among them, influenced by the expectations of Bitcoin spot ETF approval, the price of Bitcoin rose rapidly in the latter half of October, and the cryptocurrency market is expected to enter a new bull market.

Conclusion

The Federal Reserve’s interest rate hikes have had a significant impact on the national economy, leading to a continuous market decline. With the end of the Federal Reserve’s interest rate hiking cycle, the promotion of economic transformation on a national scale and the start of a new market cycle are imminent, and the cryptocurrency market is expected to enter a new bull market. However, at the same time, the expected interest rate cuts will not come immediately. The Federal Reserve still maintains a cautious attitude in adjusting its monetary policy path, and market sentiment is cautious. Investors should closely monitor market trends and plan their investment strategies reasonably.