Explainer: What does the US Fed's biggest interest rate hike in 2 decades mean for S'pore and the world?

SINGAPORE — The United States Federal Reserve (US Fed) has announced the biggest hike in its benchmark interest rate in over two decades as central banks around the world act to combat fast-rising inflation.

The Fed raised the official rate by a half percentage point on Wednesday (May 4) in a bid to quell inflation in the US, which is sitting at 40-year highs. It follows similar recent moves by central banks in Australia, India and New Zealand.

The policy-setting Federal Open Market Committee (FOMC) pushed the benchmark interest rate above 0.75 per cent as it works to cool the economy, and confirmed that more increases "will be appropriate".

The Wall Street Journal reported that more half-percentage-point increases in June and July by the Fed could be warranted depending on economic conditions then.  

TODAY spoke to economists to find out what this means for the world and for Singapore.

WHY HAS THE FED INCREASED INTEREST RATES NOW?

Economists said that raising interest rates is designed to fight inflation by making the cost of borrowing money more expensive. This means consumers and businesses, for example, are less likely to spend money, thus reducing the pressure on prices.

The high levels of inflation in the US, of about 8.5 per cent, have been caused in part by the Russia-Ukraine conflict, which has driven up energy prices. CIMB Private Bank economist Song Seng Wun said that they have also been exacerbated by increased consumer spending as the US economy reopens.

"As restrictions are being eased, we see economic activities picking up... these put pressure on prices because demand continues to be very robust," Mr Song said. 

The Fed's move is an attempt to reduce spending. 

Mr Eugene Leow, rates strategist at DBS bank, said: "Typically, this works by making loans more expensive and should lead to reduced spending."

The last time the Fed raised short-term interest rates by a half percentage point was in May 2000, as the US rebounded from the global financial crisis. It did so then with the same intention of slowing demand to keep inflation in check. 

WHAT DOES THIS MEAN FOR THE WORLD? 

Several other central banks have taken similar steps, and others are expected to follow the lead of the US, the world's largest economy.

Mr Leow said that this is driven mostly by inflation rather than a reaction to the Fed's moves, because inflation is a "global problem".  

"Many developed market central banks are already hiking (interest rates) or are thinking about hiking," he added. "These include Australia, Canada, Europe, New Zealand, the United Kingdom, (and) Asia is not spared." 

Ms Selena Ling, head of treasury and research at OCBC bank, said that the US hike means more investors will be looking to park their money in American banks to enjoy the higher interest rates. When borrowing rates increase, deposit rates usually follow.

"It puts pressure on other countries to also increase rates if not all the money will flow out from the emerging markets back into the US, because everyone says yields are going up there." 

For instance, the central bank of India had on Wednesday made an "unprecedented surprise hike" of a half percentage point to pre-empt the Fed hike. 

Many countries with international funds flowing in and out of their economies depending on investment returns are very sensitive to interest rate differentials, so they must try to maintain some parity with the Fed. 

WHAT DOES IT MEAN FOR SINGAPORE? 

Unlike other central banks, the Monetary Authority of Singapore (MAS) combats inflation by managing the country's exchange rate against its main trading partners. MAS does not directly set interest rates.

For instance, Singapore tightened its monetary policy in April with the appreciation of the Singapore dollar, to help reduce import-led inflation. 

This means that banks in Singapore will not need to increase interest rates as much as those in other countries, Ms Ling explained. 

"When you run an exchange rate policy on an appreciation bias, you can afford to have slightly lower interest rates than otherwise would have been the case," she said. "People will not just look at interest rates but the potential for your currency to appreciate." 

However, interest rates here will still rise, albeit at a slower pace, because Singapore's rates will still be determined by global interest rates, Mr Song from CIMB said.

"Our local interest rate is dependent on global interest rates... so if global interest rates start to move up, ours will be pulled along as well," he added. "But we use exchange rate to control inflation and inflation expectation.''

Agreeing, Dr Chua Hak Bin, economist with Maybank Kim Eng, said that the half-percentage-point Fed rate hike will be projected to increase both the three-month Singapore Interbank Offered Rates (Sibor) and the Singapore Overnight Rate Average (Sora) by between 0.35 and 0.4 per cent. 

Sibor and Sora are benchmark rates that are used, for example, by banks here to set some mortgage rates for property buyers.

"The translation is not one-to-one because the Singapore interest rates is a function of a weighted basket of interest rates such as the United States, Europe, China," Dr Chua said. "Investors are willing to accept a lower interest rate when the currency is expected to appreciate." 

Mr Leow from DBS said that with these projected increases, there will be rising borrowing costs in Singapore. 

"This will be the main channel where Singapore gets impacted (and) loans, including mortgages and car loans, will get more expensive," he added. "Theoretically, this could slow demand locally." 

WHAT ARE THE LONG-TERM IMPLICATIONS?

The economists said that given the Fed's plans to continue to increase interest rates, a "policy mistake" could cause a recession. 

This may happen if interest rates are raised so high and demand falls so much that a recession is triggered, Ms Ling from OCBC said. 

"The risk really is that the Fed overdoes the front-loading of the interest hikes, and it precipitates the loss of business and consumer confidence, and the US economy slows down more than it should," she said. "You may very well get a recession next year, who knows?" 

Prime Minister Lee Hsien Loong spoke recently about the likelihood of a global recession in the next two years with factors such as Russia's invasion of Ukraine clouding the outlook for Singapore's post-pandemic recovery, and the increase in energy prices setting Singapore back by about S$8 billion a year. 

Mr Song said that a recession in the US could spell trouble for Singapore's export market but so far, the demand there remains "robust" and the export market is still expected to be healthy. 

"If the US can still continue to register robust consumption growth for an export-oriented economy, this will support (demand) for our exported goods and services," he added. 

"It is only if global demand starts to slow down and interest rates start to climb to a level that makes people think about saving rather than spending, then Singapore will feel the downdraft from the pullback in consumption."