Fed Rate Hike: What Rising Inflation Means for Markets

The Federal Reserve's latest move shows how quickly the interest rate outlook can change when inflation and energy prices remain elevated for a longer than expected time period.

The Federal Reserve has hikes interest rates for the first time since July 2023 which is a reflection of the major change in monetary policy as policymakers work to control inflation. Federal Open Market Committee unanimously voted to increase the benchmark federal funds rate by 25 basis points to a range of 3.75% to 4.00% and energy prices have also risen a lot because of renewed tensions between the US and Iran and most Fed officials now expect at least one more rate increase before the end of the year.

Inflation is the biggest concern for the Fed

The Federal Reserve's latest decision is a reflection of concerns that inflation has become harder to control than previously expected. We know that Inflation had reached a generational high of 9.1% in June 2022 and the Fed raised interest rates 11 times during 2022 and 2023 to tackle it as the goal was to slow economic activity and reduce price pressures by making borrowing more expensive.

Consumers and companies often become more cautious about new debt when borrowing costs rise as policymakers may accept tighter monetary conditions for a longer period to ensure inflation comes under control. The latest projections showed that 16 of the 18 policymakers expect at least one more 25 basis point increase by the end of the year. Only two officials expect rates to be unchanged and four policymakers expect the federal funds rate to reach 4.25% to 4.5% by year end.  A rate increase also was unlikely at the start of the year as most Fed officials had expected a rate cut before the end of the year but inflation was stubbornly high in August while unemployment was relatively steady which created a new case for rate hike.

Energy Prices and the Bond Market add pressure

Geopolitical developments create additional inflationary pressure since the Fed's previous meeting in late July as the US and Iran have renewed attacks against each other. This has contributed to a sharp rise in energy prices as Brent crude has climbed to its highest level in months. Higher energy prices can push inflation higher across the wider economy.

The US bond market has also come under pressure as inflation concerns have contributed to a sell off in Treasuries. The yield on the 10 year Treasury note reached a 19 year high earlier in the week. This happened despite efforts by the US Treasury to calm the market. Treasury bonds are generally viewed as some of the safest assets in global financial markets. A significant rise in their yields can therefore have wider consequences. Higher Treasury yields often lead to higher borrowing costs across the economy. The impact can be seen in areas ranging from business loans to consumer credit. Investors will therefore closely monitor inflation, employment, energy prices and Treasury yields as these indicators will provide important clues about how the Fed may respond at its upcoming meetings.

(Source: Reuters, Guardian)