Ever since the FED has been talking about interest rates, I see questions popping up on social media where investors ask why the federal funds rate (also known as the FED interest rate) is so important for the stock and crypto markets. With this post I'd like to write an easy understandable explanation on what the FED funds rate is and why it is important.
What is the FED funds rate?
The FED funds rate is the interest rate set by the FOMC (the committee of the FED). This interest rate targets the rate at which commercial banks in the USA can lend and borrow excess money to each other. Higher rates means it's more expensive to borrow money for banks, lower rates make it cheaper.
Why is it so important?
The FOMC changes the rate in order to control . Higher rates reduce the money supply because money is more expensive to get (borrow), whilst lower rates increase the money supply because it encourages spending. The latter has happened during the 2008 Financial crisis and the more recent Corona crisis. Encouraging people to spend money generally helps the economy.
Rule of thumb: if the economy is in good shape, higher interest rates are needed to control . If the economy is in bad shape, lower interest rates will encourage people to spend and can help turn things around.
Should I be afraid of it?
Generally, no. As seen on the BTC chart above, the only time that the FED has increased the rates it did not have a effect on BTC . However, this was done during a period of lower than we currently have. To combat the current rates, the FED needs to increase the rate at a much faster and higher rate than what we have seen in the past 30 years. During the 1980's the interest rate was set to 20% in order to combat strong , I'd argue the FED has to do that as well if they don't raise the raids much faster this year. The imposed rate hikes of 0.25% every meeting are not enough to reduce the 10% year-over-year .
In case the FED decides to raise the rates with big steps (>1% per meeting), this can definitely have a huge impact on the stock- and crypto-markets. It will become much more expensive for banks to borrow (and invest) money since money will become more scarce.
There's no immediate danger for the markets. However, if spirals out of control because the FED decides not to act (keep the rates low), they'd have to increase the rates much higher and quicker than everyone anticipates, which will trigger a big sell-off in the markets. In my view, this will be the start of the next crypto bear-market.
The FED interest rates are most definitely an interesting, but also difficult topic. If you think that I've skipped an important part, please share your knowledge in the comment section. The more people know about it, the better.