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MONETARY POLICIES

Analysing Federal Reserve’s Rate Hikes

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The Federal Reserve recently increased interest rates to 1%. Policymakers voted to hike the benchmark rate by 0.25%. As you know, monetary policy is what drives currency trading. In this article, we will help you understand the significance of Fed´s recent decision and the importance of future rates hikes.

Understanding Interest Rates

Before we look at the decision, it’s important to clarify some basics. Firstly, you need to understand that interest rate changes are vital to Forex traders. Why? Rate changes affect the value of a respective currency. We’ll explore how this happens in a moment.

When a central bank alters its benchmark rate, it either acts to strengthen or weaken its currency over the long-term. In summary, an interest rate hike (or rise) strengthens a currency. Higher interest rates increase demand for a currency, namely in the form of foreign direct investment. Remember, increased demand for any asset increases its value.

Lower interest rates have the opposite effect. In this scenario, foreign investors shift their capital to countries with higher rates. Doing this ensures they get a better return.

Analysing The Decision

So let’s look at why the Federal Reserve increased its benchmark rate. For starters, it highlights the strength of the US economy. Strong job creation, low unemployment and rising inflation have all contributed to a rate hike. Chart 1 shows US job creation since 2010.

But why do these things warrant an interest rate hike? Well, the answer is quite simple. One of the Federal Reserve’s primary tasks is to control how much US goods and services cost – known as inflation.

The Federal Reserve’s target annual rate for inflation is 2%. March’s 2017’s core inflation rate was 1.7%. This is measured by the Fed’s preferred tool called the PCE price index. This means that prices for US consumers were 1.7% higher than they were in March 2016. Inflation occurs when more people spend more money – something which is commonplace in strong economies.

Clearly, inflation is starting to creep towards the Federal Reserve’s target. By increasing interest rates, the central bank is encouraging investors, businesses and consumers to slow their spending. Fed chair Janet Yellen does not want to get behind the curve. In terms of price stability, it’s easier to hike gradually now as inflation approaches 2%, rather than allow inflation to overshoot. If inflation overshoots 2% the Fed may be forced to hike rate at a faster pace.

A few weeks back, I predicted that a rate rise would happen. This was despite the market judging that the chance of a rate rise was 25% for March: “I think we should be prepared for a surprise in March. Considering the recent rhetoric from Fed Chair Janet Yellen, I think there’s a chance we could see a hike. This is especially true if data releases for US inflation and employment hold strong.”

No special information was available to me here. My prediction was simply an exercise in understanding the fundamentals.

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