Weekly Buzz: Interest rates are hitting historic highs

04 August 2023

In manoeuvres that were largely anticipated, the Federal Reserve (the Fed) and the European Central Bank (the ECB) both raised their key interest rates last week. Continued rate hikes from these central banks, in the face of sticky inflation, have now put these rates at historic highs.

What’s going on in the US?

The Fed has hiked interest rates again after a one-time pause: this time by 0.25%. This lands the fed funds rate between 5.25-5.5%, a high not seen in over two decades. The rate sets what banks charge each other for overnight lending, and feeds down to consumer rates.

It’s a complex balancing act for the Fed, inflation has to be kept in check without hurting the US economy too much. The fact that the Fed has both raised interest rates, and left the door open for further hikes reflects the policymakers’ belief that the economy’s still running too hot – fears of a wage-price spiral (check our Jargon Buster below) fuel this belief.

While a strong US economy is encouraging (it’s a silver lining we talked about in our H2 Market Outlook), soaring interest rates will put a heavy strain on it. For now, it’s proven resilient, impressive given that rates went from near zero to above 5% in just over a year. But the question is: how long can the US economy keep rolling with the punches?

What’s going on in Europe?

Across the Atlantic, the ECB hiked its deposit rate (the rate the ECB pays to banks for holding their cash) to 3.75%, matching the all-time high set in April 2001. At the same time, it lifted its main refinancing rate (the rate banks pay when borrowing money from the ECB) to 4.25%.

A high deposit rate makes banks think twice about lending money out, since they could just park their cash with the ECB. Meanwhile, a high refinancing rate makes borrowing pricier. Combined, these interest rates slow economic activity. And that’s the idea: by putting the brakes on credit, the central bank hopes to slow the economy enough to bring inflation in check.

Compared to the US, Europe's walking an even trickier tightrope between inflation and growth. While economic activity is already slowing, core inflation is still coming in at 5.5% – more than double the ECB’s 2% target. So there’s little choice: the ECB’s policymakers have to keep hiking interest rates, despite risks of a recession.

What’s coming next?

We're likely near the interest rate ceilings for both the US and Europe. Investors are already speculating about when these central banks will start rate-cutting to respond to weakening economic growth. But whatever the conditions, staying invested with a diversified portfolio (again, shameless plug: our General Investing portfolios) means you’re set for the long haul.

This article was written in collaboration with Finimize.

🎓 Jargon Buster: Wage-price spiral

The wage-price spiral suggests a dangerous tug-of-war between businesses and workers. When wages go up, workers start spending more. In response, businesses increase prices to profit on the demand. Now, workers are hit with higher costs, and to keep up, ask for even higher wages. As the name implies, it's a continuous spiral of higher wages and prices.

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