The Fed's historic rate hike: What you need to know in 6 points

Pedestrians walk past the New York Stock Exchange (NYSE) in New York.
Pedestrians walk past the New York Stock Exchange (NYSE) in New York.PHOTO: BLOOMBERG

The Federal Reserve's policymakers met for the final time this year on Wednesday (Dec 16) and announced the first US interest rate hike since June 2006, and seven years after it pushed its benchmark lending rate to zero to battle the global financial crisis and the Great Recession that followed.

Higher US interest rates will have far-reaching implications for every corner of the world economy, from your home and car loans, companies and governments' borrowing costs, to the value of currencies and commodities.

Here's what you need to know in six points:

1. What did the Fed do?

The US central bank raised its benchmark federal funds rate by a quarter of 1 percentage point to 0.25-0.50 per cent, saying the US economy is growing at a moderate pace and should accelerate next year.

The move was widely expected but nevertheless marked the end of an era - almost a decade long - in which the Fed pumped trillions of cheap dollars into the US economy to fuel what turned out to be a very long recovery.

2. Why hike rates now?

To the Fed, a rate increase represents a vote of confidence in the US economy after a long, uneven recovery from the global financial crisis and deep recession.

Fed officials now see a US economy that has made enough progress to warrant a slow retreat from cheap money. The US jobless rate has halved to 5 per cent in November from 10 per cent in 2009 and economy is growing at robust 2.1 per cent annual rate.

Inflation is still below the Fed's 2 per cent goal but officials believe it will rise in 2016 as slack in the job market diminishes and oil prices stabilise.

Economists also argue it is high time US rates were raised to prevent excessive consumer borrowing and bubbles emerging in the housing market and other types of assets.

3. What did the Fed say about future rate hikes?

It stressed in many ways that they will be "gradual".

- In its statement on the rate rise, the Fed said it "expects economic conditions will evolve in a manner that will warrant only gradual increases in the fed funds rate". To hammer home this point, it added in a second place in the statement that it anticipated "gradual adjustments" in rates.

- The Fed also stressed that when it moves next will depend on US inflation. In its statement, the Fed said it would "carefully monitor" actual and expected progress towards its inflation - implying it will be reluctant to raise rates again unless it sees inflation actually moving up.

- The Fed also noted in its statement that it will not shrink its portfolio of mortgage and Treasury securities - another way of pumping cheap money into the economy - until rate increases were "well under way". The Fed has assets of US$4.5 trillion (S$6.3 million) and shrinking the portfolio could shake up markets.

- Dr Yellen in a press conference said the benchmark rate "remains accommodative", which is Fed jargon for a level low enough to stimulate economic growth.

4. So how many more rate hikes can we expect?

Four quarter-percentage-point rate increases in 2016, four in 2017 and three or four in 2018.

This is going by new projections of what Fed officials expect their benchmark rate to creep up to - 1.375 per cent by the end of 2016, 2.375 per cent by the end of 2017 and 3.25 per cent by end-2018.

Note: This is a slower pace than projected by Fed officials in September and much slower compared to earlier series of Fed rate increases. In the 2004-06 period, for example, the Fed raised rates 17 times in succession.

5. Why does a US rate hike matter to the rest of the world?

As the world's largest economy, what happens in the US ripples out to pretty much everywhere.

While the Fed funds rate is what US banks pay each other for overnight loans, it sets the basis for longer-term rates throughout the global financial system from home and car loans to corporate loans and national debt.

Singapore home owners with mortgages or businesses with corporate loans will need to factor in higher payments.

On the plus side, savers who have seen years of very low deposit rates are likely to be better rewarded.

6. Who will be most affected?

Those who borrowed most heavily will be most affected. Economists are most concerned for emerging markets like Turkey, Brazil and Russia whose companies and governments have borrowed heavily in US currency and will now find it harder to service existing debt and attract or hold onto investments.

An era of rising US interest rates is likely to strengthen the US dollar. Many companies and countries in emerging markets have raised debt in US dollars but earn much of their income in a local currency so servicing their debt will become more expensive as the US dollar rises.

According to the Bank for International Settlements, total foreign lending to the emerging market economies has risen to more than US$3 trillion and most of it is denominated in US dollars.

Rising US interest rates also affect how investors view risk. If they can earn a more attractive return on investments in the US, they might shun investments in these riskier nations.

Higher interest rates also come at a bad time for many emerging economies, particularly those that rely on exporting commodities. The price of oil, metals and agricultural commodities have plunged so companies and governments could face higher borrowing costs at a time when earnings from mining and agriculture are falling.

And because commodities tend to be priced in US dollars, any appreciation is likely to trigger further commodity price falls.

Investors have already withdrawn a net US$500 billion from emerging markets in 2015, the first annual outflow in decades. The question now is whether the Fed move provokes a stampede.

Many emerging-market currencies are already under pressure as investors worry about the health of those economies..

On the upside, the stronger US dollar might be good for European and Asian economies as it means exports to the US will be cheaper.

Sources: Wall Street Journal, BBC, Reuters