Whenever the Fed raises interest rates, the market always wails, so what exactly is a rate hike?

In fact, the Fed's rate hike or rate cut is not a means, but the final result of monetary policy.

The Fed regulates the benchmark interest rate, which is one of the main references for market interest rates.

It mainly uses the yield of government bonds as the main variable - it is the result of a game in which multiple parties in the market pursue the maximization of interests.

The first thing to know is that every commercial bank has the freedom to independently determine its own deposit and loan interest rates.

So how does the Fed's monetary policy affect the decision-making of various commercial banks in society?

The three major tools of the Fed's monetary policy

They are to adjust the rediscount rate, open market operations, and adjust the statutory deposit reserve ratio of commercial banks.

Except the third one is to adjust the total amount of M2 currency, the first two are means of issuing USD base currency.

Adjust the rediscount rate.

Discount means the cashing of undue commercial bills by commercial banks. For example, if you have a commercial draft due in May that can be exchanged for $1 million, But you want to cash in now, And the commercial bank is now willing to buy your money order for $950,000, So you sold this commercial draft to the bank for 950,000. And the discount rate at this time is 5%.

And rediscount means that the central bank cashes the commercial bills held by commercial banks.

The lower the rediscount rate of the Federal Reserve means the higher the realizable value of commercial bills, which will increase the enthusiasm of commercial banks for discounting private commercial bills.

So the discount rate for the private sector is lower.

Because commercial banks make profits through the difference between the rediscount rate and the discount rate.

Therefore, the Federal Reserve adjusts the market interest rate by adjusting the rediscount rate, which affects the discount rate of commercial banks to the private sector.

Open market operations.

Open market operations are the above-mentioned Fed's buying and selling of securities in various secondary markets, the most important of which are bonds.

When securities are purchased in the secondary market, the US dollar base currency is issued, and the liabilities and assets increase at the same time. We can call it "expansion of the balance sheet."

Conversely, selling securities in the secondary market is tightening monetary conditions, and the liabilities and assets are reduced at the same time. We call it "shrinking the balance sheet."

How does the expansion and contraction of the Fed's balance sheet affect market interest rates?

The Fed expanded its balance sheet

In fact, it is issuing the U.S. dollar base currency, which improves currency circulation.

In doing so, it pushes up the prices of securities on the secondary market. For example, buying bonds in the bond secondary market will push up bond prices and lower bond yields.

Why do you say that pushing up bond prices will lower bond yields?

Assuming that there is a bond with a final principal and interest of 1 million due in 5 years, how much is it worth now?

It is determined by the market. Some people are willing to pay 900,000 dollar to buy it, while others are willing to pay 950,000 dollar or 980,000 dollar . In the end, the highest price will win.
Therefore, the secondary market price of bonds is the result of decisions made by both the supply and demand sides. Buying orders are greater than selling orders, which will push up prices, and selling orders that are greater than buying orders will drive down prices.

If the final transaction price is 980,000, it means that the holder holds the bond until it matures and redeems 1 million, and the profit is only 20,000.

How do bond yields affect market interest rates?

When the Federal Reserve is expanding its balance sheet, the price of bonds in the secondary market is pushed up, and the price of bonds in the primary market is bound to be pushed up.

For example, in the primary market of government bonds, the participants are generally commercial banks, and they are more willing to buy them, and then immediately sell them in the secondary market to make a difference.

As a result, government bonds can be sold at a better price more easily, and the government's financing ability becomes stronger.

In the same way, Banks are also more willing to make home mortgages if the prices of mortgage bonds like MBS are pushed up, Then package it into MBS and sell it at a high price in the secondary market to make a difference.

Banks are more willing to lend, so they will lower the loan interest rate, because they want to get more MBS and sell them on the secondary market to make a difference.

Banks, on the other hand, saw bond prices pushed up and yields lower in the secondary market,
Then the enthusiasm for buying bonds in the secondary market is reduced, and they are more inclined to use the money to issue loans to the society, which also lowers the loan interest rate.
To sum up, the expansion of the Fed's balance sheet has lowered the overall market interest rate.
Conversely, if the Fed chooses to shrink its balance sheet, it means selling bonds in the secondary market, and the increase in selling orders will drive down the price of bonds in the secondary market.

As a result, the price of the primary bond market will also be depressed, and the government's financing ability will become weaker.

The same is true for MBS. If the price of MBS in the secondary market drops, banks need to increase the loan interest rate in order to earn the same profit as before in the secondary market. As the bond yield increases, the bank sees that if the private loan interest rate does not increase, it is better to use the money to buy bonds, unless the loan interest rate also increases.

To sum up, the Fed's balance sheet shrinking behavior eventually led to an increase in overall market interest rates.