How do the Federal Reserve's decisions affect global financial markets?

Okay, no problem. Let's break this down in simple terms.

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How Do the Federal Reserve's Decisions Affect Global Financial Markets?

You can think of the Federal Reserve (Fed) as the "master faucet" of the global financial market. What flows from this faucet is the world's hardest currency – the US dollar. Because the dollar is the primary currency for global trade, investment, and reserves, when this "master faucet" is tightened or loosened, the "water level" worldwide changes accordingly.

The Fed's most crucial weapon is simple: adjusting interest rates. This is like controlling the flow of water from the faucet.

The Core Weapon: Interest Rates

Simply put, interest rates are the cost of borrowing money. The Fed primarily adjusts the "federal funds rate," which you can understand as the "wholesale price" for banks lending money to each other. When this price changes, the "retail price" that banks charge businesses and ordinary people (such as mortgage and car loan rates) also changes accordingly.

The Fed mainly does two things:

• Interest Rate Hike (Tightening the Faucet):

  • Purpose: Usually, when the economy is overheating, and inflation (prices rising too quickly) is too high. Raising interest rates is like "hitting the brakes" on the economy.
  • Effect: Borrowing money becomes more expensive, so people tend to spend and invest less, and save more. This cools down the market.

• Interest Rate Cut (Loosening the Faucet):

  • Purpose: Usually, when the economy is sluggish and needs stimulation. Cutting interest rates is like "stepping on the gas" for the economy.
  • Effect: Borrowing money becomes cheaper, encouraging businesses to invest more and people to consume more, making money more abundant in the market and revitalizing the economy.

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Why Does the World 'Tremble' When the Fed Makes a Move?

Due to the dollar's special status, these two simple actions by the Fed ripple across the globe through several channels.

1. The Dollar 'Tide' Effect

This is the most direct and powerful effect. Global money (which we call 'capital') flows like water, moving to wherever interest rates are higher and returns are better.

• When the Fed Hikes Rates: US interest rates become higher, making it more attractive to save money in US banks or buy US Treasury bonds. Consequently, global investors convert their holdings of other national currencies (e.g., Japanese Yen, Euro, Chinese Yuan) into US dollars and invest them in the US.

  • Result:
    • Dollar appreciation: Everyone rushes to buy dollars, making the dollar more expensive (appreciate).
    • Other currencies depreciate: Other countries' currencies are sold off, naturally becoming cheaper (depreciating). If you travel to Japan, you'll find you can exchange for more Yen.
    • Emerging markets suffer: Many developing countries have borrowed a significant amount of dollar-denominated debt. With the dollar appreciating, it means they need to use more of their local currency to repay the same amount of dollar debt, leading to immense pressure and potentially even triggering debt crises. This is like a "capital outflow tide," where money is drained from many countries.

• When the Fed Cuts Rates: The situation is the opposite. With lower interest rates in the US, it becomes less attractive to keep money there, so capital flows to other emerging markets with higher interest rates and greater growth potential. This is like a "capital inflow tide."

2. The 'Pricing Anchor' for Global Assets

US Treasury bonds, backed by the credit of the US government, are considered the safest assets in the world. Their yield (interest rate) serves as a 'pricing benchmark' for all risk assets globally.

• When the Fed raises interest rates, the yield on US Treasury bonds rises. For investors, if they can get such high interest without taking any risk, then risky assets (such as stocks, bonds from other countries, real estate) must offer higher returns; otherwise, investors won't buy them.
• Result: Global stock markets, bond markets, and real estate markets are revalued. Generally, interest rate hikes are bad news for stock markets because corporate borrowing costs increase, and people are more willing to buy safe US Treasury bonds.

3. Pressuring Other Nations to Respond

When the Fed hikes rates, other central banks get a headache.

• To Follow or Not to Follow?
  • If they follow suit with a rate hike: They can stabilize their currency and prevent capital outflow. However, if their domestic economy is already weak, an additional rate hike would undoubtedly make matters worse.
  • If they don't follow: Their domestic currency would depreciate significantly, capital would rapidly flow out, potentially triggering domestic financial instability.

Thus, the Fed's decisions often force other countries to make difficult choices between 'maintaining growth' and 'stabilizing exchange rates.'

4. Commodity Prices

International commodities like oil, gold, and copper are primarily priced in US dollars.

• Dollar appreciation (typically during a rate-hiking cycle): This means buyers in other countries need to spend more of their local currency to purchase the same amount of oil. Purchasing power decreases, demand may fall, leading to a decline in commodity prices.
• Dollar depreciation (typically during a rate-cutting cycle): The situation is reversed, often boosting commodity prices.

In Simple Summary

So, the next time you see news about a "Fed meeting" or "Powell's speech," you'll understand why financial professionals worldwide hold their breath. Because the switch on that "master faucet" truly affects everyone's investments and personal finances, and even the economic lifeline of nations.