Federal Reserve raises interest rate by 25 basis points – What does it mean?

US Federal Reserve raised interest rate by another 25 basis points or 0.25%, yesterday. This is the 8^th consecutive interest rate hike by the US central bank, since the beginning of 2022. With this increase, federal funds rate in US now stands at between 4.5% – 4.75%.  Federal funds rate is the rate at which overnight lending is done between banks and financial institutions in US. It effectively serves as the benchmark interest rate in the country.

After the interest rate hike announcement, US Federal Reserve Chairman, Jerome Powell, said in his press conference that inflation has started coming down. Many are expecting that the US central bank will go for another 25 basis point hike and  may then terminate the current chain of interest rate hikes. After the expected next hike of 25 basis points, Federal funds rate in US will touch 5%.

Inflation is still above the target of 2% of US Federal Reserve. In December it was 6.5%. The easing of inflationary pressure seems more due to softening of energy prices than due to the interest rate hikes of the central bank. The central bank has made the tradeoff between slowing down inflation rate and slowing down the economy.

 The successive interest rate hikes by the Fed have adversely impacted interest sensitive consumption and investment in the US economy. This has resulted in significant slowdown in many sectors of the economy, including housing.  House mortgage loans have become more expensive for US borrowers. The consensus is that due to these interest rate hikes, US economy will enter into a recession at the end of 2023 or early next year. A recession is when an economy posts negative GDP growth in two consecutive quarters. The US economy added 223,000 new non-farm jobs in December. This is the lowest number of new job additions in 2 years.

US equity markets ended in Green yesterday, after the interest rate hike announcement. The hike was as per the expectations of the markets. The indication that interest rate hikes may be paused soon brought some relief for equity markets.  

Due to interest rate hikes by the US Central Bank, other central banks such as the RBI, may also be forced to hike their interest rates. This is done as a measure to give some defense to their own currencies against the US dollar. Countries where interest rates go up tend to see their currencies appreciate too against other currencies.