Watch the Fed

This is important to us here in Trinidad and Tobago who understand that a closing of the US–TT differential on interest rate could force our monetary authority to raise rates to prevent portfolio realignment which can reduce our reserves and put pressure on our exchange rate.

The three-month TT-US differential increased by 19 basis points, reaching 86 basis points in October from 67 basis points in January of 2016, while the long-term differential (10-year Treasury differential) increased from 196 basis points in January 2016 to 256 basis points in October 2016.

Instead of seeing the US decision as a black box let us take a closer look at what they do since their decision can affect us.

The Fed is now expected to make its second rate increase since the recession in 2008. The question is, what does “raising rates” actually mean and how does it affect the economy? In reality, the raising of rates is in fact used as a catalyst to stimulate ripple effects in the economy. This means that the Fed is raising its target for the federal funds rate, the rate at which banks lend to each other, which results in an increase in the cost of borrowing money across the banking system.

Money then becomes more expensive for all banks and other institutions, and when banks and other financial institutions face higher costs, they pass those costs on to their customers in the form of higher shortterm and long-term interest rates.

When interest rates rise, financial instruments such as Treasury Bills and Bonds become more attractive to investors. Rate increases make life a bit harder for borrowers and a bit easier for savers, although there is a real possibility that neither borrowing nor deposit rates will rise. Of course, this analysis is also very reflective of effects here in this country.

Increasing interest rates for credit is expected to decrease the demand for goods which in turn is supposed to slow the growth of businesses and increase unemployment. A hike in the unemployment rate means workers have less power to demand increases and leads to decreased spending.

Some economists feel that rate changes might have less of an impact on employment than before, as not all employment sectors are sensitive to changes in interest rates due to the belief that a structural shift has occurred. This may negatively impact the ability of the Fed to guide the economy using its monetary policy.

In effect, lower spending from households and lower investment from companies mean less economic activity which would curb inflation and ensure that the growth of the economy takes place at a sustainable pace that won’t cause inflation above the Fed’s target. With decreased demand for products and services, this will serve to control prices and therefore, in essence, higher interest rates would have translated into less inflation.

The Fed can use expectations - what people expect to happen tomorrow to influence their actions today. The announcement by the Fed has the effect of influencing behaviour and for markets to react to the announcement ahead of time. Understanding and reacting appropriately to Fed behaviour can assist us to protect our foreign exchange reserves and better manage our exchange rate.

We need to keep watching.