US Fed Increased Interest Rate by 50 bps in Order to Control Inflation

The US Federal Reserve increased the interest rate by 50 bps or half percent on May 4. The central bank’s policy-setting Federal Open Market Committee voted unanimously on May 4 to increase the rate in order to curb inflation.

The increase in benchmark rate by the US Fed is seen by many as the sharpest hike in the past two decades. This also suggests that more such or even bigger hikes are on the way. With the hike, the Fed’s benchmark rate has been raised to a range of 0.75% to 1%, which takes it to the highest level since the COVID pandemic that started two years ago.

The Fed also revealed that it is going to start shoving off its $9 trillion balance sheet which primarily includes mortgage and Treasury bonds. These holdings, which got more than doubled after the pandemic in which the Fed kept on buying to arrest long-term borrowing rates.

What Led Fed Increase Interest Rate by 50 BPS?

There is no doubt that everyone was sure that such a hike was unavoidable. The Fed has also been reiterating the same for quite some time. Yesterday, however, we got confirmation of the figures. 

Curbing Inflation

The US Fed has been drawing and enduring sharp criticisms from experts for being too lazy or afraid in tightening credit. The stimulus provided by the US government in the economy has brought spending to a very high level, which started inflation. It kept on worsening after the global economy was hit by several supply chain bottlenecks and a spike in crude oil prices mainly due to the Russia-Ukraine war. The Fed finally came up with something substantial that will keep the credit in check and reduce demand in the economy, eventually keeping inflation in control.

Being Neutral

Fed Chairman Jerome Powell said the institution's immediate goal is to raise itself to a level where it neither promotes nor contains economic growth. In simple words, the Fed wants to play neutral in the US economy. From June 1, 2022, the Fed will allow bonds worth $48 billion to mature without replacement. This rate of withdrawal will reach $95 billion by September, and if the same continues, the Fed’s balance sheet will reduce by around $1 trillion a year.

Effect on the US Economy

The credit tightening by the Fed has already started producing effects on the US economy with some sectors reacting months before the actual tightening started. For example, the sales of existing homes dropped by 2.7% from February to March. This is obviously because of the hike in average mortgage interest rates. The 30-year mortgage interest rate has increased by around 2% since the start of this year. With the Fed to continue increasing rates in the coming months, the mortgage interest rate may increase further. 

Impact on Equity Market

The interest rate hike by the US Fed found its echo directly on the US equity market. NASDAQ fell by almost 5% on Thursday reacting to the previous day Fed’s announcement. The major benchmark index hit its 52-week again amid a huge sell-off by the investors. Almost all the FAANG stocks fell by more than 5% on Thursdays’ intraday trade. The US equity market worries are not only fueled by Fed rate hike. The poor quarterly performance of big market cap companies like Amazon and Netflix along with worries that companies like Apple may not be able to perform well in the next quarter has made investors pull out their wealth from the market. 

Here is a table that shows how S&P 500 Futures performed in reaction to the interest rate hike by the US Fed.

Hence, it can be seen that interest rate hike may affect the market in the short term but the stability is gained back in the long term. 

What Will Happen to Mortgage Loans and Other Credit Instruments?

Mortgage loans will definitely react directly to the interest rate. If the interest rate is increased, the banks and other lending institutions will also increase mortgage interest rates. As said, this effect is already visible in the US economy. In less than 5 months of 2022, the average 30-year mortgage interest rate has already increased by 2% and will increase further as the benchmark interest rate is going to increase more in the near future. The fixed mortgage rate spiked to 5.1% in late April, which is the highest in the past 12 months. The major sufferers will be the ones who are paying as per variable interest rate. Similarly, the credit card costs will also increase as banks and other credit card issuers will hike the APR.

Good for a Savings Account?

The hike in interest rates will have a good impact on the bank savings schemes. Banks will have to increase their savings and fixed deposits rates offered to the customers as they hike loan interest rates. However, this will not happen immediately. Although there is no direct linkage between the benchmark interest rate and savings interest rates, banks do this to attract deposits from the customers. This serves as a great alternative to borrowing from the central bank. 

Have Investments in US Stocks? What Should You Do?

There is no doubt that the US equity market is performing poorly which will also reflect on your US stock investments. However, such market slumps also present a good opportunity to make fresh investments. As we have seen, rate hikes do not produce any considerable effect on the equity market in the long term. 

• Continue the ongoing SIP investments in US equity based mutual funds if any, there is nothing to panic about.
• You can take this opportunity to but high quality US stocks which are currently trading near 52-week lows
• Refrain from making any fresh investments in debt securities, wait for the yields to cool down
• Keep the idle cash in short-term fixed income deposits once the savings interest rate increases

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