What is the FED? How does the FED rate affect the Crypto Market?

On March 22, 2023, Bitcoin fell by 4.8%, while Ethereum experienced a 4.1% decline, sending shockwaves through the investor community. This sudden price drop was directly related to the FED’s decision to raise its interest rate by 25 basis points.

Apart from this particular event, many more instances exist when the FED’s decision directly impacted the crypto market.

It raises a burning question in the mind of investors: What is FED, and why does it affect the crypto market so significantly? In this blog, we will delve into these questions in detail.

What is the FED?

FED stands for Federal Reserve System. It is the name given to the Central Bank of the USA, established by Congress on December 23, 1913, to maintain a healthy economy.

Before its establishment, the country had no reliable central bank to serve as a lender of last resort, making the economy vulnerable to collapses and bank runs. As a solution, Congress, under Woodrow Wilson's presidency, signed the 1913 Federal Reserve Act into law. This act resulted in the creation of the Federal Reserve System, comprising 12 regional banks. Each of these 12 banks is located in 12 different districts. Among these regional banks, the New York Fed is the largest and most accountable for America’s financial life balance.

The FED is often considered the most powerful financial institution due to its significant role in maintaining the world’s largest economy (USA). Its key objective involves giving the country a healthy and stable monetary and financial system. It also means setting interest rates, balancing the money supply, and regulating the different types of existing financial instruments.

Let’s talk about these responsibilities in detail.

FED Responsibilities

The overall responsibilities of the U.S. Federal Reserve can be divided into three parts:

Keeping Stable Prices

FED works to maintain stable prices across the USA. It involves keeping inflation under control to maintain the purchasing power of USD for citizens. For this purpose, FED targets a 2% inflation rate over time to keep the prices stable in the country.

Maintaining a Long-Term Interest Rate

FED is also responsible for maintaining moderate long-term interest rates that can drive sustainable economic growth of the nation. FED keeps balancing short-term interest rates to achieve this objective.

Rolling Out Sustainable Employment

Along with maintaining interest rates and prices, FED strives to create sustainable employment to help citizens make a living. It continuously monitors factors like job growth and the unemployment rate to alter its monetary policies to foster higher job creation.

To perform these responsibilities, the FED holds meetings. There, it discusses existing monetary policies and rolls out new ones favouring the country’s economy. These FED meetings are called Federal Open Market Committee Meetings or FOMC Meetings.

FOMC Meetings

The FED annually organizes at least 8 FOMC meetings to review and revise its economic and monetary policies. It also often organizes extra meetings if necessary, especially in bank-run crises or other national emergencies.

Three weeks before every FED meeting, the FED announces the agenda of the meeting. Every FOMC meeting has 12 members- 7 members from the Federal Reserve System’s Board of Governors, the Federal Reserve Bank of New York president, and 4 Reserve Bank presidents.

These FED meetings influence the economy in both long and short terms. A recent example is the series of steps FED took in FOMC meetings when the pandemic hit the world. To cope with the economic challenges presented by the pandemic, FED infused vital capital into the economy to maintain financial stability. While this step solved the problem in the short term, it affected the economy negatively in the long run. It shot up the inflation rate to 9.1% YOY (year-over-year) in mid-2022. Since then, the FED has been trying to bring it down by introducing interest rate hikes.

What Are Interest Rate Hikes?

The Interest rate hike by the FED means an increase in the federal funds rate. This federal funds rate is the interest rate at which banks and credit unions lend money to each other overnight without requiring collateral. These funds are held at the Federal Reserve. Banks with extra funds lend to those needing more. It is the collection of rates that banks can use in borrowing and lending capital.

Since 2022, this federal fund rate has risen from 0.25% to 5.50% in September 2023. This is because the FED has raised the rates about 12 times in less than two years.

Here is the tabular representation of all the hikes with their respective dates:

As you can see, the Fed interest rate hike saga started on March 17, 2022, with a 25 bps surge and then continued to rise significantly for over a year until September 2023. The next FED meeting will be held on Oct/Nov 31-1 to reconsider the rates.

How Does the FED Interest Rate Hike Affect the Economy?

As we all know, all financial Institutions are deeply intertwined due to their inherent nature and interoperability. Thus, the FED interest rate brings a ripple effect in all major financial institutions across the globe.

Here’s how this happens:

• When the Fed interest rate increases, the cost of borrowing increases, making it expensive for banks to borrow loans from the Fed and other banks.

• Since the banks get the loans at a higher rate, they also charge higher interest rates to their customers. It applies to all kinds of mortgages like credit card loans, personal loans, home loans, commercial loans, and all others.

• It means that the cost of borrowing loans for customers becomes more expensive. Thus, a Fed Interest rate hike, even a smaller one, affects the end users of the financial system.

Are you still trying to figure it out?

Let’s simplify it.

When you go to a bank to take a loan, the bank charges you an interest. This interest is the price you pay the bank for borrowing the money. But to lend you the money, banks also need the money in advance, for which they take loans from other banks or the Federal Reserve (Central Bank of USA). And just like banks charge you an interest for borrowing money from them, FED and other banks charge them an interest on borrowing the money. This interest on banks is part of the FED’s interest rate hike. Thus, with the FED’s interest rate hike, the interest rate on banks for borrowing money from the FED increases too. It results in banks charging higher interest rates to customers on loans.

FED raises Interest rates > Banks get loans at higher interest rates > Banks give loans at higher interest rates to customers

But now the question arises: how does increasing bank interest rates help the FED curb inflation?

Here’s how:

In the above section, we looked at how bank interest rates rise as the direct effect of the Fed rate hike. That means it becomes more expensive for the public to borrow money or purchase through credit cards. As a result, customers start spending less, which would lower the demand for goods in the market. Since lower demand means lower rates according to the fundamental rule of economics, the rates of goods also reduce due to decreased demand.

Let’s take the simple example of cars to see how this theory works.

Assume that 100 people want to purchase a car each and need car loans from the bank. Since the banks are charging higher interest rates on car loans, many of those 100 people would reconsider purchasing cars to avoid paying high interest to banks. Fewer people would buy cars, lowering the car demand. It will force the car sellers to lower their prices to retain customers and demand. Thus, the eventual result of a Fed rate hike is reduced car prices. The same idea works for other goods and services in the market, lowering the inflation rate of the overall economy.

So, we can say that the FED uses the interest hike to apply the brakes on the rising prices.

The effects of Interest rate hikes by the FED are not limited to the prices of goods and commodities. In fact, it sends shock waves to multiple investment markets.

Let’s understand its impact on the Crypto market.

How do Interest Rate Hikes by the FED affect the Crypto Market?

By increasing the interest rates, the Federal Reserve increases the cost of borrowing for small investors and businesses.

Since the interest rates rise, the cost of running and growing a business also surges as companies often take loans to grow. It directly results in lower earnings for the businesses. Moreover, since people avoid taking loans due to increased interest rates, they spend less and buy fewer goods, directly affecting the companies and their earnings.

It results in bearish sentiments in the share market, causing stock prices to fall. Since there has been a direct correlation between stock markets and crypto, the same bearish sentiments surface in the crypto market, causing crypto prices to fall, too.

Another explanation is that after witnessing a down day in the stock market, investors lose confidence in crypto because of its highly risky nature. Consequently, it causes crypto coins and token prices to fall. Thus, we can say that investors’ bearish sentiment is the crucial reason for the crypto market to face a downward trend when the FED raises its interest rates. Though, it is not as intimidating as it appears.

The effect of FED rates on the crypto market is often short-term, and the market balances out eventually. Moreover, traders anticipate the FED’s move to improve the situation. Thus, the market performance usually improves. It is evident from the previous start of the crypto market, where the first FED rate hike caused a strong sell-off. However, after some subsequent hikes in the following months, the impact of FED’s policies started diminishing.

How Did the FED Rate Affect Bitcoin Prices?

We have two examples to illustrate the effect of the FED rate on Bitcoin prices. These examples will help you understand the Bitcoin-FED dynamics better so that you can strategize your Bitcoin strategy before the next FED meeting.

EXAMPLE 1

In March 2023, investors expected a 0 hike in the FED’s interest rate. As a result, the Bitcoin price rose on March 22, 2023. However, the FED announced a 25 bps (0.25%) hike, causing bearish sentiments in the market. It caused a short-term psychological panic among investors, driving a 7.9% correction in the Bitcoin price.

EXAMPLE 2

Bitcoin price rose 6% in May 2022, even after the Federal Reserve raised interest rates by half a point (0.50%). This FED rate hike was the highest in 20 years and still caused a short Bitcoin rally. The reason behind this surge was that the investors were expecting an even higher interest rate hike of 0.75%. However, the FED chairman, Jarome Powell, ruled out the possibility of it, giving investors a sigh of relief. Since the investors received a rate hike lower than expected, the market sentiments turned bullish, raising the bitcoin price to 6%.

An investor can learn the below tips from the above example:

• Market reaction to FED’s interest rate hikes largely depends on the investors’ sentiments.

• Usually, when the interest rate numbers come lower than expected, it means a bullish signal for the market. Similarly, if the interest rate comes out higher than expected, it induces bearish sentiments.

• Checking investor sentiments over Fed results can help you predict market movements.

Conclusion

The Federal Reserve, aka FED, plays a crucial role in maintaining the economic health of the United States. Its responsibilities include keeping stable prices, maintaining moderate long-term interest rates, and promoting sustainable employment. To achieve them, the FED conducts Federal Open Market Committee (FOMC) meetings, reviewing and adjusting monetary policies. One significant tool at its disposal is the adjustment of interest rates, known as interest rate hikes. These hikes have a ripple effect throughout the financial system, affecting borrowing costs for banks and consumers alike. It helps the FED combat inflation by reducing consumer spending.

The impact of FED interest rate hikes extends beyond traditional financial markets, affecting the cryptocurrency market as well. When the FED raises interest rates, it increases the cost of borrowing for businesses and investors. This can lead to bearish sentiments in both the stock and crypto markets, causing prices to fall temporarily. However, the crypto market tends to recover as traders adapt to the changing economic landscape and anticipate the FED's moves.