Federal Reserve’s Interest Rates Increase and Behaviour

Why U. S. Federal Reserve increase interest rates? How does the Fed efficiently use financial information? Which effect does it make in the City of London?

After the recently increase by the Federal Reserve –U.S.’ central bank– of the interest rates, there are a number of questions up in the air. Carrying out a monetary base strategy, it tries to influence the real side of the economy by exercising a sophisticated mechanism on the financial side of the economy in order to impact on the demand for non-interest bearing money –as traditionally Keynesians support.

Basically speaking, there is a positive relation between money and the demand for cash. If income goes up so the demand for money goes up. If interest rates of bonds go up the demand for money goes down. If the transactions cost goes up, then also the demand for cash goes up. Bearing in mind the Baumol-Tobin model of the transactions demand for money (Baumol, 1952; Tobin, 1956), it can be stated that the trade-off between the liquidity provided by holding money or the ability to carry out transactions –which only applies to monetary base and possibly M1– and the interest forgone by holding one’s assets in the form of non-interest bearing money –cash– has three key variables on demand for money. These three factors are the nominal interest rate, the level of real income –the model find the optimum amount of money demand given a certain level of income– and the fixed transaction costs of transferring one’s wealth between liquid money and interest-bearing assets. In order to set the working ground for policymakers it is necessary to add up to this formulation the target every central bank wants to achieve, which is to keep inflation around the 2% as well as keeping the economy operating at its full level of employment –recalling that the latter rate differs among countries. In this context the U.S.’ central bank has taken out an ace up its sleeve by raising its interest rates to between 0.25 and 0.5 per cent.

The great question is whether the Fed will achieve its target. If it is looked at the economic theory, it can be held a blooming prospect upon the aforementioned strategy. If reality doesn’t follow the economic theory it could just due to an untrusting situation within the economy by the people. If people do not put their money inside banks yet the interest rates are higher, it indicates they don’t trust in the economy right now which wouldn’t be consistent with the economic theory. Other factor which influences the credibility of the central bank relates to its track records –the way that central bank has met what it was announced that was going to be achieved. What mainly contributes to it is the degree of dependence which central banks takes with. The more independent the central bank is the more likely is to achieve its objectives.

Another powerful tool for monetary policy target achieving is the information role. As this manoeuvre had been anticipated, it provides a great case study of the ability of financial markets to efficiently process information. The monopolistic money supplier central bank uses the aforementioned information tool to get people aware of its purposes and make them react in the way it wants them to react.

Regarding to the role that the information plays on this market situation, it can be considered the relation between the U.S. Federal Reserve information and the behaviour of interest rates. It has been found by researchers at the University of California, Berkeley that exists an asymmetry between the Fed’s and the market’s information, which would explain why interest rates of maturities rise following contradictory monetary policy actions. As economic theory of interest rates suggests, a shift by the Fed to narrow monetary policy is likely to temporarily raise short-term rates but cut them in the long run and should cut rates on bonds of long maturities. Researchers conclude that the Fed has information about future inflation that market participants do not have. The information revealed by the Fed policy actions explains the behaviour of interest rates following monetary contraction (Romer and Romer, 2000). In the light of this outcome and as economic literature backs up, a 1% increase in broad stock indexes is caused by a hypothetical unanticipated 25-basis-point cut in the Federal funds rate target. Board members of Governors of the Federal Reserve System state that “the effects of unanticipated monetary policy actions on expected excess returns account for the largest part of the response of stocks prices can explain the stock market’s reaction to the Federal Reserve policy” (Bernanke and Kuttner, 2005).

This financial manoeuvre has direct effects on the Sterling pound as it doesn’t force the hand of the Bank of England but puts pressure on it to respond. Even independent experts warn that an increase looks inevitable, there is no rush to rise rates in the U.K. following the Bank of England Governor Mark Carney’s statements. Technically speaking, an increase in US interest rates would theoretically rise the value of the dollar against the Sterling pound and other currencies such as the Eurozone. Historically, British interest rates closely followed US interest rates due to the strong financial and transactional inter-connections between both. Hence, it can be asserted that the UK is bound to follow but not yet. It could be considered this wait as a strategy to better fight against this systematic risk factor which lies ahead of the whole economy.

Enrique Muñoz-Salido
Enrique Muñoz-Salido
Enrique works in the tech industry, computer software, in the City, London. His interests lie at crossroads of human behavior and software. Enrique is an Oxford Masters graduate, Talentia scholarship.