The relationship between the Fed and financial markets is complex. Learn how changes in the monetary policy affect the markets.
In the past few years, the Federal Reserve has been at the forefront of economic headlines. After combatting the pandemic-induced economic issues with aggressive quantitative easing, interest rate hikes are now being introduced to combat high inflation.
Picture this: It’s a nice Thursday afternoon in the month of March, and a relatively inexperienced trader, Mike, opens his Binance account, he finds that his Bitcoin long has been liquidated. He sighs, and then exclaims “What? It was moving up nicely just an hour ago!”.
Struggling to find a good explanation for the market crash, he asks his more experienced trading buddy (let’s call him Abdul) for advice. After a quick back-and-forth, Mike learns that the Federal Reserve had announced a rate hike of 25 basis points, and the market apparently did not like that news.
There are many stories just like this one. Let’s help Mike out by discussing how rate hikes by Fed affect the crypto market.
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What Is the Federal Reserve?
The Fed – or Federal Reserve – is the institution tasked with maintaining the US economy. As the central bank of the United States, it has three primary objectives:
- Maximum employment
- Stable prices (i.e., low and stable inflation rate)
- Moderate interest rates in the US economy
Maximum employement: The Fed strives to create the highest level of sustainable employment, considering factors like job growth, labor force participation, and unemployment rate. By adjusting its monetary policies, the Fed can foster an economic environment that promotes job creation and stability in the labor market.
Stable prices: Keeping inflation under control is essential for fostering economic certainty, maintaining the real value of money, and promoting long-term economic growth. The Fed targets a 2% inflation rate over time as part of its price stability mandate.
Moderate long-term interest rates: Maintaining moderate long-term interest rates can generate sustainable economic growth and investment. By influencing short-term interest rates, such as the federal funds rate, the Fed can indirectly impact long-term rates and contribute to a stable and healthy financial environment.
In other words, the Federal Reserve must create an environment where prices are stable, and new jobs can be created. To do this, it monitors risks in the economy and frequently makes changes to the monetary policy.
What Is Monetary Policy?
Monetary policy is the set of rules made by the central bank of a nation – aimed at controlling the supply of money to the economy and achieving the primary objectives we just discussed (maximum employment, low and stable inflation and moderate interest rates).
Central banks can make changes to the monetary policy to combat inflation and rising prices, create new jobs or soften the effects of a recession. In that sense, monetary policy can be viewed as a toolbox for central banks to steer the economy in the desired direction.
The most well-known tools in monetary policy are quantitative easing, open market operations, interest rate changes and reserve requirements – but central banks can have many more tools at their disposal.
What Is an FOMC Meeting?
The Federal Open Market Committee (FOMC) meets at least eight times a year. If the situation calls for it, the FOMC may convene for additional emergency meetings. This most recently happened after the bank run crisis affecting two major US banks.
At the meetings, FOMC members review the economic situation and its potential risks – and discuss if the situation calls for changes to monetary policy. A notable example of this happened after the pandemic hit, and the Federal Reserve resorted to injecting capital into the economy at unprecedented rates. While this addressed problems in the short-term, it came with negative side effects: inflation skyrocketed significantly, peaking at a 9.1% year-over-year inflation rate in June 2022.
The FOMC has been working on bringing inflation back down since then, with interest rate hikes – which can affect employment and cause an economic downturn. As you can tell, the job of the FOMC is not easy.
What Are Interest Rate Hikes?
Back to interest rate hikes! When we speak of an interest rate hike, we refer to an increase in the federal funds rate, the interest rate at which commercial banks can borrow and lend money to one another overnight. The federal funds rate is a range of rates that banks can use in borrowing or lending.
Since inflation got out of control, the FOMC has decided to hike interest rates nine times, pushing interest rates from 0.25% to 5% in just over a year.
At the time of writing this article, the federal funds rate sits at 4.75% to 5.00%.
When the federal funds rate increases, the cost of capital increases. It increases the cost of borrowing for the banks, who, in turn, charge higher interest rates to their customers. Mortgages become more expensive, and the cost of commercial loans and credit card debt charges skyrocket. In other words, with a rate hike, the Fed is making it more expensive to invest or spend money – resulting in the demand curve going down.
If you’ve studied economics, you’ll know: a decline in demand usually results in lower prices. Bringing prices (and therefore inflation) down using rate hikes is like using a fire extinguisher!
Do Interest Rate Hikes Affect the Crypto Markets?
Changing the federal funds rate doesn’t just combat inflation, its effects can be felt throughout the economy, and even in financial markets. The stock market is notoriously sensitive to changes in the federal funds rate. For example, when the Fed cuts interest rates, stock markets typically move higher, because the cost of doing business goes down – which increases the profitability of publicly-traded companies.
In contrast, an interest rate hike usually pushes share prices down, as the cost of doing business increases – cutting earnings. Because of the correlation between stock markets and crypto – a bearish reaction in the stock market also results in a downturn for your tokens.
Nevertheless, the biggest short-term effects of rate hikes are psychological. Markets are great at pricing in information, and they often move in anticipation of FOMC decisions. For example, the market pushed higher on March 22nd, expecting a rate hike pause. When the FED announced the recent 25 basis point rate hike, a 7.9% correction in the Bitcoin price happened.
At the start of this rate hike cycle, the announcement of a 25 basis-point hike came as a surprise, resulting in a strong sell-off. Now that we’ve made it through nine consecutive hikes, the effect of new rate hike decisions has waned slightly. While it still provides a decent dose of volatility, the market generally retraces the correction quite effectively, bringing the market back to the level it traded before the rate hike announcement. The market has grown accustomed to rate hikes.
Closing Thoughts
All in all, it is clear that the Fed has a strong influence on financial markets. Their quantitative easing program pushed asset prices to all-time highs in 2021, and rate hike decisions have pushed prices back down in the past year.
At this moment, the market has become more used to rate hikes, and their impact on short-term prices has waned. It is incredibly difficult to predict interest rate decisions, and even harder to predict their effect on the market. Nevertheless, it is useful to have a basic understanding of the driving forces behind economies – and it will help you understand why markets move the way that they do.
For further reading, check out our articles on stagflation and quantitative easing.
Writer’s Disclaimer: This article is based on my limited knowledge and experience. It has been written for educational purposes. It should not be construed as advice in any shape or form. Please do your own research.
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