US interest rate rises: everything you wanted to know (but were afraid to ask)

An interest rate rise from the Federal Reserve is on its way. What will it mean for the global economy?

Eagle-eyed: investors are closely watching the US Fed's decision on interest rates

The world’s most influential central bank is poised to pull the trigger on its first interest rate increase since 2006 - a move that has investors around the world set on edge.

Analysts have combed over the data and debated what each policymaker will consider when deciding on the path for US interest rates.

But why are the Federal Reserve’s actions on rates so important, and why has it taken so long for policymakers to decide to adjust the central bank’s rates?

What do we mean when we talk about rates?

When we discuss US interest rates we’re typically talking about the Federal Reserve’s primary tool: the Federal Funds Target Rate.

The central bank uses open market operations - buying and selling securities in an open market - to steer interest rates into its target range.

This range has remained unchanged since December 2008, when it was cut to between 0pc and 0.25pc.

Will higher rates mean a better deal for savers?

Higher central bank interest rates usually help to cool down the economy, preventing it from running too hot. That means slowing growth and, in turn, inflation.

Other things we call interest rates - savings rates offered by your bank, or the costs of servicing debt such as loans and mortgages - often track changes in central bank rates. So a higher Federal Funds Rate will probably mean that creditors do better, and debtors worse.

But this isn’t always the case. Sometimes - when central bank rate decisions are unexpected - the opposite happens. When central banks put up rates too quickly, this can have adverse effects for savers too.

If the economy is cooled down too aggressively by the Fed, then it could fall into recession, reducing the returns on investments and penalising savers. Two economists have showed that shock changes in central bank policy rates have had this effect.

Long-term interest rates follow changes in the Federal Funds Rate when movements are anticipated

But the relationship breaks down when Federal Reserve decisions come as a shock

Scott Sumner, chair of monetary policy at the Mercatus Center, has said that a Federal Reserve rate rise might well be better for savers for a year or two, but “will lead to lower interest rates in years two through 20” as it reduces growth.

What will happen to the US economy when interest rates do rise?

Deutsche Bank has looked over all the US tightening cycles since 1950 - there have been 12 to date - and found that from six to 18 months after the first hike, growth slows incrementally as further interest rate rises occur.

"These readings probably reflect a traditional textbook rate hiking cycle where the Fed feels comfortable raising rates due to activity levels rising and inflation pressures building and one where activity levels take several quarters to be impacted," economists at the German bank said.

But it's not clear how higher rates will be received this time around. The economy has "endured a uniquely slow recovery" Deutsche Bank said, and it's been a record-breaking run without a rate hike. It's not obvious how markets will react.

A rate hike, when it does come, isn't likely to be as high as in previous recoveries. Deutsche calculated that on average the Federal Funds Rate increased by 4.95pc over a hiking cycle. But analysts are not confident that the Fed will increase rates as sharply again.

This may be explained by the idea of secular stagnation - that for some reason, the natural rate of interest is falling. That might be because the global economy isn't able to replicate the growth rates of the past, or because there's a global savings glut.

Whatever the reason, it could prevent policymakers from returning rates to their pre-crisis levels.

And what will happen to the rest of the world?

Premature Fed rate hikes could threaten the world's emerging markets, many of which have large amounts of dollar-denominated debts.

If rate raises happen sooner than expected, or if rates rise more quickly than anticipated once that first hike takes place, then the value of the US dollar is likely to rise.

Emerging markets could be hit if the dollar rises following a rate hike

This could make things very difficult for countries which have to repay their debts in dollars, and could cause a growth crunch in parts of the world far away.

There have already been hints at nervousness from emerging market investors, during the so-called "Taper Tantrum".

When former Fed chairman Ben Bernanke made moves towards ending the Fed’s QE purchases in 2013, the threat of a higher US dollar caused turmoil in foreign exchange and debt markets.

If US policymakers are too eager to raise rates this time around, other economies could be battered again, jolting the global recovery.

Why has the Federal Reserve left its rate so low for so long?

The central bank is instructed to pursue a dual mandate - steering the economy towards stable inflation, and promoting maximum employment.

On one front, the US economy has delivered a punchy performance. Delivering three months of consecutive job growth, the unemployment rate dropped to 5.1pc in August, its lowest since April 2008.

It’s also the level the Fed judges to reflect “full employment”. This would in normal times be enough to spur it into action. But at the same time, inflation remains lacklustre.

The Federal Open Market Committee - which decides on what the Fed’s rates should be - said in July that it was looking for “some further improvement” in the labour market, which would provide “reasonable confidence” that inflation would pick up towards its target level.

The central bank is mandated to achieve annual inflation of 2pc.

Inflation continues to linger well beneath that level, with prices ticking up by just 0.3pc in the year to July. Policymakers remain cautious as rate hikes could tip the balance on inflation, potentially pushing price growth below zero.

Stanley Fischer, the Fed’s vice chairman, said in August: “The problem is not with the part that’s unusual in the dual mandate, namely employment, that’s doing just fine. It’s with the inflation part.”

But recent turbulence in emerging markets - particularly China - has pushed back expectations of a rate rise. While markets were just a month ago pricing in a first hike in September, they now expect the US central bank to wait until December.
