The Fed Hike: The Cause and Effect

Since December 2015, the Federal Reserve Board (Fed) has increased their interest rates by three times. The second in 2016 and the third – this March 2017. For many, this is quite something as they have not heard of Fed increasing their interest rates since it was brought to near zero in 2009. Therefore, the usual question is, “what is the effect of the Fed interest rate hike? And what are the implications to the Philippine economy? But not a lot would ask, why is Fed increasing their interest rates? For if we know the cause of such interest rate hikes, then we can also understand the effect of it.

The reason why Fed is increasing their interest rate is because inflation is showing up. The idea of higher interest rate intends to arrest the negative effects of inflation to manage the growth of the economy. Remember that inflation is a sign of economic activity. Its upward pace of higher prices due to improved economic conditions is definitely good. However, if it is not contained, can be equally damaging to an economy. An upward spiral of prices and uncontrollable at that, could bring an economy down. This type of situations have been experienced by many countries in the past, including Philippines. In the 80s, Philippines experienced hyper-inflation. Since prices of goods kept climbing, the natural tendency was for the price of money to go up as well - that is interest rates. And if interest rates go up or cost of money goes up, business will not flourish. The cost of high borrowing rates will discourage business people. Likewise, consumers will not borrow money to purchase capital goods or durable items. Therefore, these behaviors over high interest rates would cripple an economy. Hence, to counter such, policy interest rates would have to be increased. By increasing interest rates, it incentivizes people to hold on to the US Dollar. It will likewise attract money from circulation to be deposited in a bank. By doing so, the inflationary pressure is eased and managed. Therefore, one conclusion that can be drawn out of an increased interest rates is that the economy is performing well.

How about the effect?

For countries like the Philippines or any country in Asia who interact with the US either trade or investments could be affected. For the Philippines, the clear signal is that when US rates are increased, the stock market reacts negatively. In 2015, we saw the PSEi index going above 8,000 points the first time. But the news of possible interest rate hike dampened market sentiment and brought the index to about 6,000 points in less than 9 months. The reason for this is essentially, foreign funds started exiting the equities market. They sold their profitable positions, buy back their US dollars and repatriate back to mainland US. Similarly, the Philippine peso tumbled against the US Dollar as foreign funds exited. It continued in 2016 as the second round of increased happened. The market wobbled as well but not as much as in 2015. Reports say the foreign funds that exited in 2016 amounted to about US$ 17 billion. However, for the whole year, the net foreign investments in the financial markets was an inflow of about US$ 354 million. The 2016 effect of Fed hike was not as bad as that of 2015.

So for the third time, Fed hiked their interest rate this March 2017, the market did not react negatively. The reason – perhaps, is that the bulk of these funds have gone out or that the market has factored in these rate hikes as it was announced beforehand. Therefore, the effect is not that much in the short term as the market has expected it. However, the long term effect is more interesting as it speaks of the US economy recovering from the damages of the 2008 global financial crisis. So, if the US economy is going to grow, it only spells good news for the rest of the world.

While there are short term negative effects of a Fed Hike to our country. Our own internal economic resilience could offset this quickly. What is important is that we are on track towards future growth prospects and that a trade partner such as US is doing well would only add on to the opportunities that will crop up in the future.