Simply put, the federal funds rate is the interest rate at which commercial banks in the US lend money to each other, usually overnight. The rate is generally only applicable to the most creditworthy institutions and applies to balances held at the Federal Reserve - called federal funds. In order to support the economy after the financial crash, the rate has persisted at a near-zero level. In what some analysts have described as a "baby step" towards normality, the Fed has doubled the interest rate by 0.25% to 0.5%.
With the financial hangover wearing off following the collapse of the housing and banking sectors between 2007-09, the Fed is clearly signalling that the US economy is now strong enough to weather an interest rate hike. Unemployment is at 5% (down from its peak of 10% in 2009) and has reached the point at which wages are starting to rise rapidly and push up inflation.
The ripple effect…
The federal funds rate is viewed as the base rate for all other interest rates in the US and sets a benchmark for the level of credit and borrowing costs. The higher the federal funds rate, the more expensive it is to borrow money, which is likely to lower the amount of money in circulation. The effects of a rate hike are transmitted through to banks and consumers. The aim is to cool down the economy and control inflation to avoid a scenario in which demand (i.e. available money) exceeds the supply of goods and services.
A rate rise has a wide and varied impact. Although the Fed’s change is unlikely to have immediate impact on longer-term rates, the rate has a knock-on effect to rates paid by firms and households. Businesses can expect a net increase in costs as borrowing money will become more expensive as will paying off debts already incurred. The change is also likely to be transmitted to consumers who borrow money from banks. These consumers can expect changes to interest rates on products such as car loans, credit cards and mortgages.
Although the link is more tenuous, there is also a broad interaction with the stock market. Businesses need to borrow money from banks to run and expand operations. Because of the higher rates of interest on loans, companies may borrow less, slowing down their growth. Businesses are also affected by the behaviour of individuals, who may have less discretionary income to spend. Higher debt expenses and decreased revenue from customers will be reflected in a lower price of the company’s stock.
What about the UK?
Historically, UK interest rates have moved in tandem with the US market interest rates. Although there is no direct link between the UK and US interest rates, there exists an expectation that the Bank of England will be the next central bank to hike rates. The current UK economy appears to support this expectation: the UK was the fastest growing economy in the G7 last year and its economy has been growing for eleven consecutive quarters. The UK deficit is down and the economy has experienced record high employment.
Despite this, risks in the UK economy remain. Recent economic growth figures released by the Office for National Statistics (“ONS”) have revised Britain’s growth downwards, suggesting that the recovery was losing momentum. In particular, the ONS cited weakness in the key services sector. Other commentators have noted slowing wage growth and continued low inflation. This is the fourth time in the last seven quarters where the ONS overestimated the strength of the economy.
Mark Carney, the Governor of the Bank of England, recently said that the Fed’s decision was not decisive and that any rates rise would be “limited and gradual.” Most economists do not expect any increase in the UK interest rate until the second half of the year, adding that any rates rise would only be a marginal 0.5% to 1% over 2016 as a whole. It remains to be seen whether the federal funds rate hike will have any significant impact on UK rates.
The immediate reaction to the rate hike was one of relief and world markets have reacted positively. The Fed has hinted towards a gradual upwards trend, avoiding the need for more substantial (and potentially economically damaging) rises in rates later on. Further incremental increases in the federal funds rate are expected later in 2016.