Three key variables—interest rates, stock market value, and the crypto market—have a significant impact on the economy and investors.
In the global economy, three key variables—interest rates, stock market value, and the crypto market—hold a profound influence over the economy and investors. These three factors are crucial not only in terms of importance but also in their mutual interactions. A change in any one of these factors can lead to substantial and significant changes in the other two variables.
In this article, we comprehensively examine the impact and interactions between interest rates, stock market value, and the crypto market.
For example, changes in interest rates can significantly affect the stock market. Higher interest rates may lead to a drop in stock prices as they are seen as a more attractive investment alternative. Conversely, lower rates can boost the stock market as investor demand increases.
The crypto market also plays a role. Higher interest rates may enhance the crypto market’s relative advantages over stocks, given crypto’s generally higher interest rates. Meanwhile, crypto price volatility is a critical factor for investors’ decision-making in the stock market.
Thus, understanding the interaction between these three economic variables is crucial, helping policymakers and investors make informed decisions. This article seeks to explore these dynamics in detail and highlight their importance for the global economy.
What is the Interest Rate?
Interest rates are the most powerful and fundamental tool for central banks to control and manage the economy. Raising or lowering rates alters monetary balance and liquidity in economic networks, impacting financial markets significantly. This article explores how interest rates affect financial markets, especially stock and crypto markets (Cryptocurrency). It also reviews the historical trend of U.S. Federal Reserve rate hikes and recent changes. The importance of U.S. interest rates lies in their substantial impact on cryptocurrency markets and their role in shaping market dynamics.
What is the U.S. Federal Reserve’s Interest Rate?
The Federal Reserve’s interest rate report, released eight times a year by the Federal Open Market Committee (FOMC), contains crucial insights into the U.S. economy. The interest rate is vital for determining a currency’s value and reflects the economic state. For example, when the Federal Reserve lowers rates, borrowing costs for banks decrease, leading to increased demand for bank loans. This can also lower the dollar’s value against other currencies. When the rate rises, the opposite effect occurs, strengthening the dollar relative to other currencies and commodities. Interest rates impact economic conditions in the short, medium, and long term.
“The interest rate is the percentage of the reward paid on the amount of money deposited in an account.” -Irving Fisher, the great economist
As noted by economist Irving Fisher, U.S. interest rate changes significantly affect currency exchange rates, commodity prices, stock markets, cryptocurrencies, and other economic factors. For example, rising rates may trigger short-term fluctuations, leading to currency exchange rate declines and other financial market impacts.
Persistent increases or decreases in interest rates can have substantial long-term effects across various markets. Rate hikes may help curb inflation and manage economic pressures, although they could also weaken the national currency relative to others. On the other hand, rate cuts may stimulate economic growth and increase demand but could also drive up inflation.
Given the economic influence of the U.S., its interest rates have a profound effect on global markets, particularly digital currencies, shaping major and long-term trends in these markets.
If we look at Bitcoin (BTC) analysis charts from March 2022 onward, we see that with consecutive rate hikes, Bitcoin’s downward trend intensified. Rate changes can impact financial and cryptocurrency markets over varying short- and long-term periods.
Since the Federal Reserve’s rate hikes, both Bitcoin and global gold prices have fluctuated. This shows the direct and indirect effects of U.S. interest rates on multiple markets, helping investors and economic policymakers make better asset management and investment decisions.
Why Interest Rates Matter in the Economy
Interest rates impact the economy so extensively that they can influence both inflation and controlled inflation, acting as a central bank’s key tool for economic management and financial stability. Interest rates are used as a primary monetary policy instrument.
The central bank directly influences inflation and money demand by adjusting rates. Higher rates reduce inflation by decreasing demand for goods and services, while lower rates increase demand, potentially leading to higher inflation.
As a critical economic variable, interest rates broadly impact all financial markets, including currency rates, stock markets, and gold prices. When the U.S. Federal Reserve adjusts rates, the effects ultimately resonate across global financial markets.
Therefore, as one of the most significant economic determinants, interest rates play a crucial role. Known as the “price of money,” this base rate serves as a benchmark for other interest rates in financial markets, influencing both global and financial economies directly and indirectly.
The economic significance of interest rates is vast, affecting inflation, inflation control, and serving as a central tool for economic management and balance within the general financial and economic framework.
How Does the Interest Rate Affect the Economy?
The Federal Reserve, often regarded as one of the most influential monetary institutions in the U.S., plays a critical role in shaping both American and global financial markets. Its policy decisions, especially regarding interest rates, have profound impacts on the economy.
Interest rates, a primary monetary tool for the Federal Reserve, significantly influence economic conditions. When the Federal Reserve lowers interest rates, it typically encourages investments, boosts production, and generates employment. Conversely, raising interest rates can help control inflation, manage market liquidity, and prevent unchecked price increases.
In terms of inflation, increasing the interest rate can alleviate inflationary pressures. This measure helps adjust overall inflation and has a direct impact on purchasing decisions and prices within the economy. On the flip side, such actions can influence stock markets and investments, potentially affecting certain shareholders.
In recent years, the Federal Reserve has adopted a contractionary approach, which involved raising interest rates to curb inflation and stabilize the financial market, particularly in response to COVID-19’s economic downturn. While this decision might negatively affect the stock market, it helps control inflation and maintain economic stability.
Why Do Interest Rates Fluctuate?
The Federal Reserve, aiming to sustain economic stability, price stability, consumer protection, and the dollar’s value, has numerous responsibilities. Among its essential tasks is ensuring price stability, which entails keeping inflation at manageable, steady levels so people can save without fearing rampant inflation. Inflation also impacts key economic indicators like retail sales, a major element of the U.S. economy.
During recessions or periods of reduced economic activity, the Federal Reserve often lowers interest rates to encourage borrowing among businesses and promote investments. This approach aids in economic recovery. In stronger economic times, the Fed may raise interest rates to regulate business activity and consumer spending. Adjusting rates is intended to smooth out economic fluctuations, reduce the severity of recessions, and prevent overproduction, thus avoiding market crashes and heightened inflation volatility.
The Recent Rise in U.S. Interest Rates Due to Inflation
During the COVID-19 pandemic, the Federal Reserve printed money and injected it into the U.S. economy to prevent an economic crisis caused by social distancing policies. Another strategy was to lower interest rates, which ultimately contributed to inflation in the U.S. economy. At the end of 2021, Federal Reserve Chair Jerome Powell announced plans to raise interest rates in 2022 to manage inflation, marking interest rate hikes as a key strategy to control inflation and restore economic balance in the U.S.
Controlling inflation is crucial as it directly affects economic growth if prices become unstable. This issue previously afflicted the U.S. economy in the 1970s, a period marked by prolonged inflation that significantly impacted the American economy.
Today, the Federal Reserve understands the need to control inflation; otherwise, the American economy could face severe challenges. The chronic inflation of the 1970s illustrated that unchecked inflation could severely harm the economy, underscoring the importance of managing inflation for a healthy and stable economy.
Historical Interest Rate Trends of the U.S. Central Bank
Since its mandate to achieve maximum employment and price stability, the Federal Reserve has targeted a 2% annual inflation rate since 2012.
The Fed’s goal has been to maintain a positive inflation rate, meaning a gradual increase in overall prices and services, as persistent price declines, known as “deflation,” could harm the economy. Additionally, positive inflation and interest rates provide the central bank flexibility to reduce rates in response to economic downturns.
In August 2020, the Federal Reserve adopted an average inflation targeting policy, committing to keep inflation slightly above 2% for some time.
Raising interest rates typically helps lower inflation and boost economic momentum. Since early 2022, with global inflation pressures due to events like the Russia-Ukraine conflict and their impact on the U.S. economy, the Federal Reserve opted for rate hikes.
The central bank, aiming to curb inflation, has raised interest rates ten times since March 2022, pushing the rate to around 5.5%.
Interest rates, as the most significant macroeconomic indicator, are wielded as a powerful management tool by central banks.
Interest Rate Cycles
Throughout history, the Federal Reserve has implemented various policies based on the overall economic climate. The following chart illustrates interest rate changes in the U.S. from the 1950s to the present, with two distinctly different cycles. From the 1950s through the 1980s, the trend was upward. In 1981, the U.S. interest rate peaked at over 20% annually.
After the early 1980s, the upward trend reversed, and a downward trajectory began due to the Federal Reserve’s success in addressing chronic, problematic inflation from the 1970s.
Following the 2008 financial crisis, the Obama administration kept interest rates at a low level, around 0.25%, for several years. This policy contributed to prolonged bullish trends in the U.S. stock market. However, these policies, combined with the massive monetary stimulus during the COVID-19 pandemic and interest rates below 0.25%, created economic risks, now evidenced in rising inflation rates.
Post-COVID Inflation and Interest Rates
To save the economy from the COVID-19-induced recession, aggressive monetary policies, including extensive money printing and drastic rate cuts, were implemented. This injection of liquidity sharply increased inflation.
In the last quarter of 2021, the surge in inflation became evident. In response, Jerome Powell announced rate hikes for 2022. Consequently, the sequential rate increases during the first half of 2022 helped slow inflation growth. Yet, a 1.9% inflation rate in June indicated that further rate hikes were needed. In late July, a Federal Reserve meeting concluded with a 1% rate increase, crucial for managing inflation and strengthening the U.S. economy.
This was followed by the third rate hike to 1.75%, which was intended to counter inflation and strengthen economic stability.
In March 2022, Powell assured the U.S. Senate that the Federal Reserve would take any necessary steps to control inflation, even if such actions negatively impacted the country’s economic growth. By year-end, the central bank’s rate reached 2.4%, rising to approximately 3.5% at the start of 2023.
Pausing Interest Rate Hikes
It is noteworthy that in the Federal Reserve’s eleventh meeting held on July 26, 2023, the U.S. interest rate was increased by a quarter-point (0.25%) to reach 5.5%. However, in its September meeting, the U.S. central bank decided to maintain the interest rate at the previous level of 5.5%, refraining from any further rate increases or cuts.
Following ten consecutive rate hikes over a campaign lasting more than a year, the Federal Reserve has decided to pause this policy, opting to keep rates stable within the current 5-5.5% range. However, this decision is considered temporary, as the Federal Reserve may revisit rate adjustments depending on future economic conditions.
In response to the troubling inflation situation in the United States, unprecedented in recent decades, the Federal Reserve considered lowering its policy rate. This move may be influenced by recent domestic events, including the banking crisis, which led to the bankruptcy and closure of several banks. Meanwhile, the steady rise in job numbers is also stabilizing.
This measure by the Federal Reserve offers a breathing space for the U.S. economy, which had been under continuous pressure from successive interest rate hikes. The coming months will be an ideal time to assess the impact of the Federal Reserve’s stringent policies to see how effective these strategies and contractionary policies have been.
The Relationship Between Interest Rates and the Crypto Market
Most people see cryptocurrencies as a hedge against inflation, recessions, declining purchasing power, and even fiat currencies like the dollar. While this belief is generally correct, it holds only until the crypto market encounters a broader economic crisis.
When interest rates or inflation increase, circulating money and the Federal Reserve’s balance sheet decrease, thus combating inflation. In such cases, people’s purchasing power falls, shifting the fear and greed index toward fear.
As fear spreads across the market, investors’ risk-aversion reaches a peak, and they prefer low-risk investments like bonds or real estate over high-risk assets like stocks or crypto.
This lower motivation among investors to enter the cryptocurrency market, combined with negative market sentiment, leads to a drop in the value of crypto assets.
The Link Between Bitcoin and U.S. Interest Rates
Economic shocks and startling news can cause abrupt and significant changes in financial markets. Bitcoin and other cryptocurrencies are also exposed to these types of fluctuations. An increase in interest rates, inflation, political news, or other factors can impact the cryptocurrency market.
As a cryptocurrency investor, it is essential to make financial decisions based on credible sources and comprehensive analyses, and be prepared to face market volatility and sudden changes. Risk management, strategic financial planning, and a long-term financial outlook can help you navigate various market conditions.
When interest rates rise, it brings multiple effects on the economy, including reducing circulating money, shrinking the central bank’s balance sheet, and raising borrowing costs for both individuals and businesses. When money supply tightens and higher prices impact people and businesses, public company values fall, leading to a decline in stock prices. In turn, individuals have less disposable income for investing. This situation can lead investors to pause or even sell assets such as stocks and cryptocurrencies. Higher interest rates make government bonds more attractive, which directs investors toward safer assets.
Thus, when interest rates rise, it creates a spillover effect on cryptocurrencies like Bitcoin, leading to a price drop. This overflow effect, caused by reduced economic activity, investment, and trade, creates an unfavorable environment for Bitcoin and other cryptocurrencies.
The Effect of Interest Rate Increases on the Stock Market
The impact of financial markets and institutions on economic growth is considered essential in improving societal welfare. These markets play a vital role in achieving the growth and development of countries’ foundations.
The stock market, as a component of capital markets, can harness available savings and deploy financial resources to enhance production cycles and promote economic development. However, stock values are continually influenced by various factors, particularly fluctuations. Macroeconomic variables directly impact the trajectory of the capital market.
If the central bank allows banks to raise their deposit interest rates for customers, people will lean toward holding money in bank deposit accounts to earn risk-free returns, adjusting their financial plans accordingly. This causes a decline in stock market investment, adversely impacting market momentum.
Moreover, higher interest rates on loans reduce the demand for loans from individuals and companies. Those with outstanding debt must pay higher interest costs, making them less inclined to seek loans. This issue can lead to reduced capital and halt company growth and expansion.
In general, rising interest rates in financial markets negatively affect stock growth and investment, potentially leading to a market downturn.
Interest Rate Impact on Stock Market Volatility
Although the stock market is relatively more sensitive to interest rate changes than the crypto market, the latter is still affected by rate fluctuations. Higher rates can alter investor behavior in the crypto market, as this market responds differently than the stock market to various sensitivities.
Higher interest rates can lead to reduced purchasing power, decreasing demand and company profits. This can result in declines in the stock of various sectors, particularly in diversified markets.
In the crypto market, technology-based companies, due to their reliance on future profits and investor confidence in their long-term performance, may be more affected. However, as mentioned earlier, past experiences show these companies have a degree of sensitivity to interest rate changes.
Some sectors of the market, such as industries and government indices, may be better positioned to perform acceptably despite higher interest rates. However, each market’s situation can be highly variable, and the crypto market is always subject to spillover effects from other markets.
Conclusion
This article emphasizes three key variables—interest rates, stock market value, and the crypto market—and their significant impact on the global economy and investor decision-making. The findings indicate that changes in any one of these variables can deeply affect the others. Based on the discussions, changes in interest rates significantly influence stock market value, where increased rates may lead to lower stock prices, while lower rates can boost stock values. Additionally, the article addresses the crypto market’s sensitivity to rate changes, highlighting that shifts in interest rates can provide relative advantages to the crypto market compared to the stock market. This comprehensive review of the interplay between these three variables underscores that a deeper understanding of these dynamics can aid policymakers and investors in making better decisions, thereby enhancing economic impact analysis and forecasting.
