Spend Matters welcomes this guest article by Avneet Kaur Deol, of Mintec.
On Dec. 16, for the first time in almost a decade, the U.S. Federal Reserve raised the benchmark interest rate for the first time since 2006 by 0.25 percentage points. In the article below, we discuss what prompted the increase, instant reactions around the world and how the rest of the world could be affected.
Prior to the rate rise decision, U.S. interest rates had been near zero since 2008. The range of overnight rates that banks offer to lend to each other will rise to between 0.25% and 0.5%.
The interest rate rise had been much anticipated and signalled faith that economic activity has recovered since the financial crisis. Strong growth in household spending and business fixed investment in recent months, as well as expansion to the housing sector, spurred the decision. In addition, the unemployment rate has fallen to prerecession levels, at 5% in October, satisfying the first leg of the Fed’s dual mandate to maximize employment and stabilize prices.
It wasn’t all good news though. The Fed recognized that inflation remained below the long term target of 2%, partly due to the sharp fall in energy prices. While the Fed acknowledged this fact, it remained fairly confident that inflation will rise to the 2% target in the medium term. It also accepted the risks associated with slow economic growth in the overseas markets, emphasizing that further adjustments to interest rates would be gradual.
In the wake of the announcement, stock markets around the world were positive on the news. Wall Street saw the Dow Jones up 1.3%, and the Japanese benchmark Nikkei 225 closed up 1.6%. The FTSE 100 index in the U.K. opened the morning after the announcement over 1.5% higher. Other European markets mirrored the increase, with Frankfurt's DAX up more than 3%, and CAC 40 in Paris rose 2.2%. Interest rates are not usually considered good for stocks markets, as they make borrowing more difficult, but the markets rallied as the interest rate drew a line under the financial crisis. Investors were also reassured by the careful and considered increase and the fact that future rises are expected to be equally measured.
Understandably, the main banks were also quick to respond, with JPMorgan Chase, Citibank and Wells Fargo all raising their prime lending rate the next day. U.S. bank customers will now pay a base rate of 3.5% for loans, rather than 3.25%. The U.S. dollar strengthened on the news also. As the rise was anticipated, commodity prices have only reacted slightly to the news. The price of crude oil fell for a few days but has since risen slightly. The opposite was true for gold. Prices rose for a few days but have now fallen slightly as fundamental factors return as the price drivers.
An increase in interest rates in the world’s largest economy will, no doubt, have a ripple effect on the rest of the world. Most commodities are traded in U.S. dollars, and therefore commodity driven economies, such as China, Brazil, Russia and Australia, have suffered recently due to a decline in global prices coupled with the strong dollar. A strengthening greenback will also make debt more expensive, for countries that have borrowed in dollars.