March 15th, 2017, Wednesday, was an interesting day:
For couple of reasons:
First, the Consumer Price Index (CPI) figures were announced by the Bureau of Labor Statistics (BLS). BLS announces the CPI on a monthly basis. The percentage change in the CPI from one month to another is called monthly inflation. The CPI moved up by 0.1% in February (from January). The annual inflation – the movement from month to the same month in the previous year - came in at 2.7%.
Second, the Federal Reserve Bank (FED) increased its "target" overnight borrowing rate, to a 0.75 - 1% band. In other words, the minimum interest rate that the banks can charge to each other can not be lower than the lower limit of the band. It also has consequences: an increase in that overnight rate will cause an increase in all other interest rates, like mortgage rates, auto loan rates, etc.
Why are these pieces of information important for us? Let's step back and take a look.
BLS news on inflation noted that it was pretty high (2.7%!!!); it also noted that the FED had been trying to reach higher inflation levels for a while. So why has the FED been so obsessed with inflation rates over the last few years?
Here is the answer:
When the economy was not performing so well, I mean when there was less buying and selling of goods and services in general, the FED used its interest rate weapon to stimulate the economy. The general idea in macroeconomics is that lower interest rates can help people to borrow at lower costs; businesses can also easily borrow to increase their activities.
Therefore, the interest rate can be explained simply as the cost of borrowing (any type of borrowing funds, be it for mortgages, auto loans, student loans, credit cards, and so forth). So, in a healthy economy, consumers demand good and services. They want to spend their income so that this spending can, in turn, be the income of someone else (you buy from me, I buy from your friend, etc). However, the aggregate demand, the demand for all goods and services in the economy, is hard to keep the track of. Imagine the whole U.S. and everybody's spending action.... Then the question is how can we understand when the economy is heating up, in other words, is there any demand for goods, is there any action in the markets!!! (in general)?
So the answer comes here from basic economics: if there is an increase in demand for any good, it becomes more expensive (assuming the supply is not changing or changing less than demand).
FED tracks the CPI numbers, so it is aware of the inflation rate. A higher consumer price level is a sign for FED that aggregate demand is high in the market, therefore the economy is heating up (more action's going on). In other words, FED uses inflation announcements as an indicator to understand the state of the economy.
What does the FED want? What is the task of the FED?
The FED needs to satisfy price stability, foster economic activity and maintain high employment. That is very simple: only 3 things!!!! phewwww! Good luck with that!
So, how does the FED achieve these goals?
But first, does the FED have any target number in mind for these 3 things? Yes, actually, it has. In general, these objectives are 2% for annual inflation, 5% for unemployment rate, and 2-3% economic growth(GDP).
Let's go back to see how FED tries to reach these goals in the economy?
There is, again, only one weapon: which is........???? the INTEREST RATE.
The idea is to use the interest rate weapon. But this time in an opposite way:
If the interest rate, the cost of borrowing or the cost of holding money at home! (yes, you lose interest income if you keep your money under your bed instead of in a bank) is HIGH, people are not going to be able to borrow easily because it will be expensive; and if they don’t borrow, they will not spend. Instead they will take the money out from under the bed and put it in a bank for an interest income.
This way FED can stop the hyperactivity in the economy and the economy “cools down.” Yes, the economy is a living organism, because we are living it, we are creating it :)
This is what happened yesterday. The FED conveyed a signal that they believe the economy is creating too much action, and it is causing inflation. They have decided it is time to cool down the economy.
From here, what I am trying to explain is a basic idea about the causal relationship between inflation and interest rate. As you can follow, FED uses inflation as a signal to affect the interest rate. This is the sequence when the economy is in good state. In other words, a higher inflation rate caused a higher interest rate. Inflation is the reason why the interest rates have been changed. If you need to write it in an equation, you might write:
Interest Rate = a + b.Inflation + e
(even if FED did not act as increase interest rate, inflation will lead to spend the money more, which will make money more valuable, then interest rate will increase in the market anyways. Here, FED only applied its contractionary monetary policy to stop increase in inflation).
In this equation, change in inflation will cause a change in interest rate.
The point missing here is that the FED cannot change the interest rate by just saying so. It has to make the money (dollars you use everyday) less available in the economy, to increase the cost of borrowing money (interest rate). (As you can see if something is less available, then its price will be higher: again basic demand and supply analysis at work!).
Therefore, FED has a tool to change the amount of dollars floating around in the economy: They sell US government bonds to the banks. When banks buy these US Treasury bills (T-bills), they pay in dollars, so the amount of money in banks (or potentially those that would remain in our pocket) will be less in the economy. The FED sells these T-bills at the Open Market at such a point till that they reach their target rate. that is why it is considered a 'target' but not the actual value. You can see that the daily federal funds rate is varying around the target rate.
There are different discussions on the relationship between inflation and the interest rate; I will explain these later, in another note.
The FED's decision on interest rate affects the value of the US Dollar (USD) against other currencies. It also affects stock prices of firms in the U.S. and foreign markets. It affects even the commodity prices, like oil.
The answer is not easy since the economy is very dynamic - like us. Think about it, your short-term temperament and long term behavior are very different from each other.
I will try to look at the instant effect, and daily effect in the market because what behavioral economics and finance tell us that people have short memories. We react today and then forget! We are more emotional to actions in the moment. Our expectations might change in the long-run as well.
So, if the interest rate increases, it makes the US dollar more valuable (because there is less available). Recall that the FED sells US Treasury bills with a higher interest rate. Money flows to the US to purchase these higher interest rate bonds!!!. As a result there will be a demand for the USD. And if you are holding Euros (or any other currency), and if you want to buy US T-Bonds, you need green dollars. Every country sells their own version of T-bonds mostly in their own currency (if not, then it is called Eurobonds, a general name, and nothing to do with Euros). If the FED sells US T-bonds at a higher interest rate, and you want to buy these, you need to get rid of your Euros - and exchange them for nice green USD's! As you can see, again demand and supply. If you, me and everyone else will want to keep USD and get rid of other currencies, so the demand for USD increases in the foreign exchange(FX) market, so is the price of the USD! It becomes more and more valuable. In other words, USD appreciates in terms of other currency.
Did USD appreciate yesterday?
Again, the economy and the markets are living organism like us. Like us, they live on expectations. The FED's action was expected for a long time by the market players. So if something is already expected, where is the fun part of the surprise? It’s already HAPPENED!
No surprise, no appreciation of USD.
It is a success for the FED. They managed to increase interest rate without any appreciation of USD! The chair, Dr. Janet Yellen, managed this process very smoothly. My applause goes to her.
More, FED did it by purpose all these time for the last 3 years. It was a very smart move on their part, if they planned it in advance I give them credit. They had not increased the target interest rate for the last 3 years, but in every FED meeting they waved their stick at us and stated that they may – today, maybe tomorrow - increase the int. rate. So market players got ready and created that expectation. So if you already know there is a surprise party for you, when you open the door hearing the sound of "SURPRIIIIISEE" does not have the same effect on you. Does it?
Even more, the FED has increased the interest rate a little bit, suggesting there is still time for another rate hike in the future. So people run to the markets and buy stocks, foreign markets open high today (march 16th). Instead of holding USD, they buy foreign stocks, Asian stocks, and Japanese Yen. As a result, the USD depreciated (lost value against Euro).
The oil price is next...
"If, and when, the Federal Reserve raises interest rates, oil speculators may very well operate under the assumption that the interest rate hike will cause the dollar to appreciate. Alternatively, some expect speculators to act in the opposite direction. If speculators forecast a depreciated dollar, they will buy into oil and may cause a price bump." *
It is exactly happened like that: crude oil prices increased yesterday from 2-4:30 pm by 1.8%. It went up to $51.81 from $50.92
More on the CPI and FED annoucements effect on stock and commodity markets later...
Figure 1: The intraday USD/EURO currency on March 15th, 2017-Wednesday.**
The graph show the PRICE of USD in terms of EURO.
As you can see the 1USD was equal to 0.942 EUROS highest, then it closed to today cheaper! The price of $1 ended as 0.93Euros! although FED increased the target federal funds rate! (Less valuable dollar is not a bad thing, on the contrary our goods become more competitive with the rest of the world. Strong dollar hurts trade).
If you are interested in reading more on the U.S. macroeconomic news announcements effect on emerging markets stock prices, you can check out some of my papers here:
It is at U. of New Haven digital commons page: http://digitalcommons.newhaven.edu/economics-facpubs/3/