A Comprehensive Guide to Understanding the Principles and Processes of the U.S. Interest Rate Hikes and Cuts (Recommended for Bookmarking)

Why discuss interest rate hikes and cuts? Because they directly affect the liquidity of the crypto market, U.S. stocks, and even global markets, determining the direction of financial cycles. It’s no exaggeration to say that rate hikes often lead to bear markets with tighter liquidity, while rate cuts typically result in bull markets with looser liquidity, making their impact significant.

Historical data from the past 40 years supports the following conclusions about interest rate policies:

1/ Federal Reserve’s continuous rate hike cycles: When CPI exceeds 3% and unemployment falls below 5.6%, the priority is controlling inflation. During this phase, the economy is robust, and despite continuous rate hikes, unemployment tends to decline amid strong economic recovery.

2/ Federal Reserve’s pause in rate hike cycles: (1) In non-financial crisis scenarios, when the unemployment rate exceeds 4% and CPI drops below 3.7%, the Fed halts rate hikes.

(2) During financial crises, even if CPI exceeds 4%, rate hikes stop when unemployment rises above 4%, with job preservation taking precedence over inflation control.

3/ Federal Reserve’s continuous rate cut cycles: When CPI approaches 2% or unemployment exceeds 4%, inflation is not a concern, and reducing unemployment becomes the priority.

4/ Federal Reserve’s pause in rate cut cycles: (1) In non-financial crisis situations, when CPI climbs above 2% and continues rising, rate cuts stop, even if unemployment exceeds 5.6%.

(2) During financial crises, when rates are at zero, the Fed maintains current rates as inflation typically remains low, and unemployment gradually improves as the crisis is resolved.

Part One: Why Does the Federal Reserve Repeatedly Raise and Lower Interest Rates? What Is the Process for U.S. Money Printing and Bond Issuance?

First, the Federal Reserve (Fed) is essentially the central bank of the United States. In theory, it holds the same status as central banks in other countries, but it differs in a crucial way. Although its board members are nominated by the President and confirmed by Congress, the Fed is not part of the U.S. government—it operates independently. Because of the “gold standard of the U.S. dollar,” the Fed effectively serves as the “world’s central bank.”

Thus, the Fed has two roles: it acts as the central bank of the United States and, in a narrower sense, as the “world’s central bank.” As the U.S. central bank, it has the responsibility and obligation to manage the nation’s economy. Officially, the Fed focuses primarily on two key economic indicators: the unemployment rate and inflation.

To understand the Fed’s rate hikes and cuts, it is first necessary to grasp how the U.S. prints money and issues debt. The Fed cannot directly print money; it is a currency-issuing institution. According to the Federal Reserve Act, any money the Fed issues must be backed by assets. In the past, these assets included precious metals, securities, and commercial paper. Today, U.S. Treasury bonds are the primary asset used.

For the Fed to print money, it must acquire corresponding Treasury bonds. The process begins when the Fed uses previously issued bonds to register assets with the U.S. Treasury. Upon receiving these bonds, the Treasury authorizes its Bureau of Engraving and Printing (BEP) to print money, which is then delivered to the Fed.

Once the Fed obtains the money, it must inject it into the market for the money printing to take effect. At this stage, the U.S. government comes into play. While the government cannot print money directly, it can issue Treasury bonds on behalf of the nation. These bonds are the same type used earlier by the Fed for collateral registration with the Treasury.

The issuance of government bonds requires approval from Congress. Once Congress gives the green light, the Treasury can proceed with bond issuance. This synchronization between government bond issuance and money printing is carefully coordinated. The amount of dollars printed corresponds directly to the amount of Treasury bonds issued. The Fed then uses the freshly printed dollars from the BEP to purchase the newly issued Treasury bonds. This process is often referred to as “moving money from one hand to the other.” In this transaction, the government receives the cash, and the Fed acquires the bonds.

When the Fed needs to print more money in the future, it repeats the process using the previously acquired bonds to register new collateral with the Treasury. Although this explanation simplifies the process, the actual operations are far more complex.

Part Two: The Transmission Mechanism and Impact of Federal Reserve Rate Hikes

In the first part, we explained that the Federal Reserve ultimately holds a large amount of U.S. Treasury bonds, which are valuable securities. Treasury bonds, especially those from major economies, are universally recognized as relatively “risk-free assets.” When the Fed aims to reduce U.S. inflation, it implements rate hikes. This process involves two actions: “raising interest rates” and “balance sheet reduction,” which are used in combination. The rate increase targets the “federal funds rate.” All banks conducting business must submit a “reserve requirement” to the central bank. However, banks sometimes face liquidity shortages, leading them to borrow money from one another, partly to meet the reserve requirement.

When banks lend to each other, they charge interest on these loans, known as the “interbank lending rate.” This rate is determined by the banks themselves, without direct involvement from the Fed. However, the Fed influences the interbank lending rate by adjusting the federal funds rate. The primary tools for raising the federal funds rate are increasing the “interest on excess reserves” and the “overnight reverse repurchase agreement (reverse repo) rate.”

When these two rates rise, commercial banks realize that depositing money with the Fed becomes more profitable than lending to other banks. As a result, banks compete to lend to the Fed, driving up the interbank lending rate. Borrowing between banks becomes more difficult and costly, marking the completion of the “rate hike” process.

Let’s continue with the explanation of “balance sheet reduction.” Balance sheet reduction refers to the Federal Reserve selling the U.S. Treasury bonds it previously bought from the U.S. government. Since these bonds are being sold, the price must be reduced. For example, a bond originally worth $100 may be sold to commercial banks for $80. Assuming the bond’s original annual coupon rate is 10%, it would pay $110 (principal plus interest) after one year to the holder. Now, due to the sale, the commercial bank effectively buys the bond for $80, which originally had a face value of $100.

(110 - 80) / 80 * 100% = 37.5%

This is the new yield for the bond after its price drops to $80. You can see which option is more attractive. Commercial banks will rush to buy the Treasury bonds from the Federal Reserve. The high interest rate on the bonds is one reason, but another key reason is that Treasury bonds are assets, which the Federal Reserve uses to guarantee the issuance of money with the Treasury Department. As long as commercial banks hold Treasury bonds, they can always exchange them for cash whenever needed.

After this cycle of actions between the Federal Reserve, the U.S. government, and commercial banks, what changes will occur? Let’s start with the stock market, which is likely to experience a sharp decline in major indexes. The primary reason is that when the interest on bank savings becomes higher and safer, most capital will choose to withdraw money from the stock market and deposit it in banks. We all know that the more you sell in the stock market, the further prices drop. However, large capital, such as that held by companies like Warren Buffett’s, will act differently. They will use their funds to support their stock prices, creating a “false prosperity” in the market. Once their funds have flowed back into the U.S., they will sell at high prices and cash out! What remains are retail investors and small institutions trapped in the market!

Next, let’s talk about U.S. businesses and citizens. Because the Federal Reserve raised interest rates, banks have lent all their money to the Federal Reserve to buy U.S. Treasury bonds, leaving them with little money. Banks must now attract more deposits to lend again to the Federal Reserve to buy more bonds. As long as the interest rate offered on deposits is lower than the interest rate on Treasury bonds, banks can profit from the “interest rate spread” or “spread between deposits and loans.” At the same time, because the interest rate on lending to the Federal Reserve is higher, banks will not lend to businesses. As a result, businesses face higher borrowing costs. Borrowing from banks is seen as riskier than buying Treasury bonds. Even if businesses are willing to offer 50% interest rates, U.S. banks will still be reluctant to lend to them. If businesses can’t get the funds they need, their cash flow will break down, leading to bankruptcies, layoffs, and higher unemployment.

When bank deposit interest rates rise, and people, seeing the stock market crash, decide it’s safer to just put their money in the bank to earn high interest, the scale of bank deposit business will increase dramatically! With everyone depositing their money in banks, the money in circulation decreases, making money more valuable! As consumption declines, businesses, in order to survive, will have to lower prices to encourage people to buy goods. As goods become cheaper, “inflation” will naturally be reduced!

Next, let’s talk about loans in the U.S. Most American businesses and individuals opt for floating-rate loans. These loans have lower initial interest rates, are easier to get approved, and allow for higher loan amounts. However, the downside of floating-rate loans is that when the U.S. dollar interest rate rises, borrowers must pay off their loans quickly, or else the interest on the loan will continue to climb. After a U.S. rate hike, anyone who has borrowed in dollars, whether in the U.S. or abroad, will need to quickly convert their money into dollars and pay off their loans. If they can’t, it’s a dead end!

Now, let’s consider the impact on other countries after a U.S. rate hike. After the U.S. raises interest rates, other countries that previously held dollars will see the value of their holdings increase. For example, if I bought a house in Europe with $100,000 before the rate hike, the house might have appreciated over the years due to a flood of dollars into the market. When the U.S. raises interest rates, the value of my property, originally worth $100,000, could now be worth $180,000.

When the dollar appreciates after a rate hike, it causes the currencies of other countries to depreciate! My $180,000 property, priced in euros in Europe, becomes less valuable because the euro has depreciated against the dollar. At this point, my property won’t appreciate further, so selling it and converting the money into dollars to deposit in a U.S. bank for high interest becomes a better option! Similar assets, such as local stocks, government bonds, luxury cars, yachts, business equity, precious metals, luxury goods, antiques, etc., will also be sold, and their proceeds converted into dollars and sent to U.S. banks, causing these assets to plummet in value. My property, originally bought for $100,000, may now drop to $30,000 after the rate hike. The slower I sell, the greater my losses! The property, which appreciated from $100,000 to $180,000, was sold at a profit, taking both the principal and the increase. In the end, wealth is drained from the target country!

Finally, after the rate hike, the Federal Reserve, fearing that the dollars won’t return or may flow elsewhere, typically resorts to a move that solves the issue: creating local instability or tensions outside the U.S. This way, capital is reminded that the U.S. is the safest place. Those of you who are interested in political affairs can recall how every dollar interest rate hike is usually accompanied by events that are unfavorable to other countries or regions—such as wars, energy conflicts, government changes, or food crises. It’s always the same recipe, with the same familiar taste, and it hasn’t changed in decades!

Part 3: The Transmission Mechanism and Impact of the Federal Reserve’s Interest Rate Cuts

When will the Federal Reserve start cutting interest rates after raising them? Interest rates are likely to be cut when the U.S. unemployment rate reaches around 5% or the inflation index (core PCE) drops to 2%! As of the end of September this year, the U.S. unemployment rate was 3.5% and the core PCE inflation index was 5.1%. When both of these indicators return to normal or near-normal levels, it will signal that the Fed will stop raising rates. When inflation decreases and the unemployment rate rises, this is called “recession” or “economic stagnation,” and then the Fed will start a rate-cutting cycle!

Rate cuts are accompanied by other actions, such as “interest rate cuts” and “balance sheet expansion.” The Federal Reserve will announce that it is implementing “quantitative easing,” which means it will cut interest rates. The interest rate being cut is the “federal funds rate,” which was discussed in the second section. After that comes “balance sheet expansion,” which means the Federal Reserve will accumulate assets and increase the assets on its balance sheet. So, what are these assets? U.S. Treasury bonds are the easiest assets for the Federal Reserve to acquire, so during a period of expansion, two methods are used:

The first method is for the Federal Reserve to directly repurchase large amounts of Treasury bonds from commercial banks. These bonds are the ones the Federal Reserve had previously sold at low prices to commercial banks during the interest rate hike cycle. The Treasury bonds go to the Federal Reserve, and the dollars go to the commercial banks, meaning money flows back into the market!

The second method is for the Federal Reserve to print money directly. After registering assets with the Treasury Department, the Federal Reserve prints new money, and the Treasury Department also issues corresponding new Treasury bonds. The Federal Reserve then buys up all the new Treasury bonds, and the newly printed money flows into the market through the U.S. government!

The new Treasury bonds, along with the bonds the Federal Reserve repurchased from commercial banks, will now be concentrated in the hands of the Federal Reserve. The Federal Reserve’s assets will expand, completing the “balance sheet expansion” process. The new-issued Treasury bonds, new-issued dollars, and the bonds the Federal Reserve repurchased from commercial banks cause the yields on Treasury bonds and the dollar to depreciate! A flood of dollars rushes out of the U.S., seeking appreciation opportunities around the world! This flow of dollars due to rate cuts is like releasing a hungry wolf dog—it will pounce on everything it can consume!

Once banks receive a large amount of dollars, they will look for ways to make the money appreciate. Bank loan rates will be lowered, even to 0% in some cases. Then, businesses and individuals will start borrowing like crazy to finance production and consumption, and the scale of bank deposits will drop sharply. With businesses having money to expand, job positions will increase, and the unemployment rate will begin to fall. But with more consumption and money in the market, prices will start to rise, leading to inflation!

The Federal Reserve’s rate cuts will also lower bank deposit interest rates, and capital will take its money out for consumption. The remaining funds will flow into various high-risk investment sectors, such as the stock market, real estate market, currency markets, precious metals, and more!

Of course, the U.S. market alone can’t absorb such a large amount of dollars. As mentioned earlier, these dollars will flood out of the U.S. to “hunt” for opportunities. Wherever they go, they will encounter various assets and investment opportunities at bargain prices, leading to a “buy-buy-buy” mode. This will trigger economic booms, stock market surges, currency appreciation, asset price increases, and inflation in the target countries. This is when the entire rate-cutting process is complete!

At the end, some of you may wonder, when will the rate cuts stop, and when will rate hikes begin again? It really depends on the U.S. “unemployment rate” and “inflation index.” Once these two indicators deviate too much, a new cycle of rate hikes and cuts will begin.

Assuming all other variables remain unchanged, theoretically, if the U.S. cuts interest rates, the following will happen:

U.S. stocks? ——- Rise
U.S. bonds? ——- Rise
Other countries’ stocks? ——- Rise
U.S. dollar? ——- Depreciate
Other countries’ currencies? ——- Appreciate
Gold price? ——- Rise
Oil price? ——- Rise
U.S. real estate? ——- Rise
Cryptocurrency? ——- Rise
Let me emphasize again, these are theoretical market responses, assuming all other variables remain unchanged.

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