The Federal Reserve: Exploring The Interest Rate Hike

Jarratt Davis

Special Consultant to the FPA
The Federal Reserve recently increased interest rates to 1%. Policymakers voted to hike the benchmark rate by 0.25%. As you know, monetary policy is what drives currency trading. To help you understand the significance of yesterday’s decision, I’ve published a new post entitled ‘The Federal Reserve: Exploring The Interest Rate Hike’.

Interest Rate Basics
But before we look at the decision, it’s important to clarify some basics. Firstly, you need to understand that interest rate changes are vital to Forex traders. Why? Rate changes affect the value of a respective currency. We’ll explore how this happens in a moment.

But first, I want you to understand how I trade. Quite simply, my trading replicates institutional methods. It’s based on tracking the fundamentals and current sentiment. I also use technical analysis but the sentiment and fundamentals are always more important. I look at the events which move the markets and analyse their impact on currency value. Trust me, this is how professionals trade. If you follow and perfect this way of trading, you’ll have a great chance of success. The video below explains my thinking.

So back to interest rates. When a central bank alters its benchmark rate, it either acts to strengthen or weaken its currency over the long-term.
In summary, an interest rate hike (or rise) strengthens a currency. Higher interest rates increase demand for a currency, namely in the form of foreign direct investment. Remember, increased demand for any asset increases its value.

Lower interest rates have the opposite effect. In this scenario, foreign investors shift their capital to countries with higher rates. Doing this ensures they get a better return.

Analysing The Decision
So let’s look at why the Federal Reserve increased its benchmark rate. For starters, it highlights the strength of the US economy. Strong job creation, low unemployment and rising inflation have all contributed to a rate hike.

But why do these things warrant an interest rate hike? Well, the answer is quite simple. One of the Federal Reserve’s primary tasks is to control how much US goods and services cost – known as inflation.

The Federal Reserve’s target annual rate for inflation is 2%. March’s 2017’s core inflation rate was 1.7%. This is measured by the Fed’s preferred tool called the PCE price index. This means that prices for US consumers were 1.7% higher than they were in March 2016. Inflation occurs when more people spend more money – something which is commonplace in strong economies.

Clearly, inflation is starting to creep towards the Federal Reserve’s target. By increasing interest rates, the central bank is encouraging investors, businesses and consumers to slow their spending. Fed chair Janet Yellen does not want to get behind the curve. In terms of price stability, it’s easier to hike gradually now as inflation approaches 2% rather than allow inflation to overshoot. If inflation overshoots 2% the Feb may be forced to hike rate at a faster pace.

A few weeks back, I predicted that a rate rise would happen in my blog post. This was despite the market judging that the chance of a rate rise was 25% for March.

“I think we should be prepared for a surprise in March. Considering the recent rhetoric
from Fed Chair Janet Yellen, I think there’s a chance we could see a hike.
This is especially true if data releases for US inflation and
employment hold strong.”

No special information was available to me here. My prediction was simply an exercise in understanding the fundamentals.

Why Did The Dollar Fall?
Considering what I’ve explained above, you might be asking why the US dollar fell following yesterday’s rate decision.

This is an excellent example of why traders should be familiar with market sentiment 100% of the time. The truth is that an interest rate hike was widely expected in the days before the decision. While that’s good news for the US dollar over the longer-term, it was unlikely to strengthen in the hours after the Fed’s decision.

What professional investors were paying attention to is the Fed’s new Dot Plot chart. The last Dot Plot chart, published in December 2016, told us to expect three interest rate hikes in 2017. The new Dot Plot chart didn’t change this forecast. This is why the US dollar fell.There was an expectation that more than three interest rate hikes for 2017 could be possible. The market became over excited on the prospect of more than 3 hikes. When that expectation met the Fed’s reality of only 3, the USD weakened.

Future Interest Rate Hikes
So two more interest rate hikes are on the cards for 2017. Again this is a signal of a strong US economy and US dollar.

However, we’re in uncharted territory when it comes to the US economy. The Obama administration, which secured the economic recovery, is no longer in office. President Trump is now implementing his fiscal plans. They are a stark contrast to what has gone before.

My prediction is that President Trump’s plans increase the chance of more interest rate hikes. This is because his policies are extremely pro-business. Low taxation and a significant stimulus plan for US manufacturing are inflationary. That’s to say they will encourage investors and businesses to spend more money in the US.

There are caveats to this prediction, though. This hiking cycle that the US is in needs very careful balancing. If interest rates become too high, job creation and consumer demand could fall.

Also, there remain questions around the timing of Trump’s policy implementation. Currently, President Trump and the Republican Party are trying to finalise new healthcare legislation. There have been suggestions that tax reform will only happen after healthcare. Needless to say, the partisan politics of the US could delay this for quite some time.

Plus, we’ve yet to see the effects of Trump’s trade and foreign policy. Remember, the markets are incredibly sensitive to geopolitical confrontation. The same sentiment applies to political scandal. Should The White House become entangled in controversy, the markets will get jittery.
One story that could lead to something substantial is Trump’s wiretapping allegation against the Obama administration. My advice to traders is to watch this story closely.

The Federal Reserve: Exploring The Interest Rate Hike
I hope this article has provided some insight on why interest rate changes are important. After nearly a decade without a rate hike from the Fed, we’ve had two in the space of three months.

We’re definitely entering an interesting period in relation to Federal Reserve monetary policy. I think this is a period where Forex traders who understand fundamental analysis will flourish. Those who can understand and interpret the Fed’s next move will have the best opportunities to make profitable trades. Now is the time to master fundamental analysis.

Time for a pop quiz! This will test your understanding of this article and the Fed meeting. What triggered the USD selloff at Marches FOMC meeting? Click here to take the test!

If you have any questions regarding the Federal Reserve or their monetary policy, please leave a comment below. I’ll do my best to reply to as many as I can.