- On 14 June the Federal Reserve raised interest rates by a quarter of a point, the second increase of the year.
- It announced it would begin to reduce its balance sheet later on, another way of tightening financial conditions.
- Anyone with loans linked to the dollar or to variable rates should check how a further increase would affect them.
On 14 June 2017 the Federal Reserve raised interest rates by a quarter of a point, the second increase of the year, and announced that it would begin to reduce its balance sheet later on. They were two signals pointing in the same direction: the US central bank was continuing to withdraw, gradually and with advance messages, the extraordinary support it had given the economy in the years after the crisis.
The news was no surprise, because markets already expected the rise, but it confirmed a course that matters beyond US borders. When the central bank of the world’s largest economy tightens its policy, the effect is transmitted to currencies, debt markets and the financing conditions of companies and states around the world, with varying intensity in each case. That is why the US central bank’s decisions are followed around the world with the same attention as one’s own.
A policy returning to normal
After years of very low rates, the Fed was gradually withdrawing the stimulus applied since the crisis. Raising rates slowly aims to avoid overheating the economy without braking growth abruptly. It is a difficult balance: acting too early or too forcefully can smother the recovery; waiting too long can allow tensions to build up in prices and credit.
Gradualism and advance communication are part of the strategy. Announcing in advance what one intends to do allows companies, banks and families to adapt without shocks. That is why the Fed’s moves are usually already priced in by the markets before they happen, and what matters most is what they suggest about the future pace. That pace, and not just each rise, is what determines the cost of money in the medium term.
A central bank’s balance sheet
The balance sheet holds the assets the central bank accumulated by buying bonds to inject liquidity. Reducing it means withdrawing part of that support: it is another way of tightening financial conditions, in addition to raising official rates. During the crisis, those purchases helped to keep long-term rates low; ceasing to replace them tends, over time, to do the opposite. It is a less familiar tool than interest rates, but it also influences the cost of money.
It is a new process, of considerable size, whose exact effect nobody knows precisely. That is why the Fed insisted that it would be done gradually and predictably. For the rest of the world, the simple reading is that the era of extraordinarily cheap money was coming to an end, albeit slowly, and that plans based on very cheap financing deserved a review.
Effects for companies and families
Across the world, dollar money becomes somewhat more expensive, and this tends to show up in currencies, in corporate financing and in emerging markets. Anyone with loans linked to the dollar or to variable rates should check how a further increase would affect them. The same goes for companies that borrow in dollars without income in that currency, which also take on exchange-rate risk.
In practice, the recommended exercise is simple: calculate how much the instalment or financial cost would rise if rates were one or two points higher, and check whether the plan can bear it. If not, it is worth talking to the bank or an adviser about alternatives, such as fixing part of the rate or extending maturities. Gradual changes are easy to ignore, but ignoring them for too long tends to prove expensive.
Gradual changes are easy to ignore and expensive to ignore for too long.
This article is general information. It is not legal, tax or investment advice, and it does not take anyone’s particular circumstances into account.
