There has been a breathtaking change in the approach to monetary policy in the US over the last 12 months. On Wednesday 2nd November Jerome Powell the head of the Federal Reserve (US central bank) announced a 0.75% increase in its benchmark lending rate (officially known as the Federal Funds Rate) to between 3.75% and 4%. This is the third time the Federal Reserve has made such a significant increase in interest rates. With the rise in inflation in the US to 8.2% the Federal Reserve is using contractionary monetary policy in an attempt to aggressively reduce the rate at which consumer prices are increasing.

This benchmark interest rate is the rate the federal reserve charges to the US commercial banking system. A rise in the benchmark rate means commercial banks will have to pay more to the Federal Reserve and they will in turn pass on higher interest rates to households and businesses. Money markets interest rates are also influenced by the Federal Reserve’s benchmark interest rate and this rate will move higher as well. 

This general rise in US interest rates triggered by the Federal Reserve’s decision is significantly increasing borrowing costs for consumers and producers. US mortgage rates on house purchases have increased from an average of 3% to 7% in the last 12 months. This means the annual interest cost on a $300,000 mortgage has risen from $9000 to $21000 - more than doubling the interest cost of financing someone's home.

Source Trading Economics

In contrast, higher interest rates are good for savers with US deposit rates increasing from an average of 2% to 5%. A $10,000 deposit in a US bank will now yield $500 a year up from $200.

The combination of higher borrowing costs and savings rates could lead to a fall in US consumption spending as households borrow less and save more, although the most recent data for US consumption spending is that it is holding up with a 0.4% rise last month.

Higher US interest rates will have an impact on investment spending by businesses that, like households, will face higher borrowing costs and will receive higher returns on cash they hold in the bank. Both of these consequences will increase the opportunity cost of investment and could lead to a fall in its rate.

The action taken on interest rates by the Federal Reserve has had a significant impact on the value of the US dollar. Investment flows of foreign currency (portfolio and direct) have moved into the dollar as investors seek out higher returns in US interest-bearing assets. The US dollar index measures the value of the dollar against a basket of currencies and over the last 12 months it has increased by 14%

Possible questions to discuss with a class

1. How does the US benchmark interest rate affect the interest rates paid by firms and households?
2. Why do central banks increase interest rates when inflation rises?
3. Why might US aggregate demand fall when US interest rates increase?
4. How has the rise in US interest rates affected the value of the dollar?