Complete Explanation of Rate Hikes: How Do Central Banks Use Rate Hikes to Regulate the Economy?

Recent frequent interest rate hikes by central banks around the world have been featured prominently in financial news. The Federal Reserve’s every rate decision influences global financial markets. But what exactly does a rate hike mean? Why do central banks raise interest rates? These seemingly distant policy decisions directly impact our borrowing costs, salary levels, shopping prices, and investment returns. This article will delve into the essence of rate hikes, their mechanisms, and how investors should respond to a rising interest rate environment.

Meaning and Basic Concepts of Rate Hikes

A rate hike refers to a central bank increasing the benchmark interest rate, while a rate cut is a decrease in the benchmark rate. Both operations are important tools for central banks to regulate money supply, directly reflecting their monetary policy stance.

By adjusting the benchmark interest rate, central banks can influence the overall money supply in society, which in turn has profound effects on commodity prices, labor markets, and economic growth. Different countries use different interest rate indicators, but the goal is always to maintain economic stability.

Mechanisms of Rate Hikes and Cuts

Taking the U.S. Federal Reserve (Fed) as an example, its rate hike mechanism is relatively straightforward. When the Fed raises the overnight borrowing rate, the cost of interbank lending increases, prompting banks to raise loan rates for individuals and businesses. This creates a high-interest environment, making borrowing expensive and suppressing consumer spending.

Conversely, during economic downturns, the Fed lowers the overnight rate, enabling banks to borrow from each other at lower costs and lend to the public at lower rates. Such a low-interest environment encourages borrowing and spending, stimulating economic growth.

Taiwan’s central bank employs a different mechanism. Taiwan influences the borrowing rate between the central bank and commercial banks by adjusting the discount rate, which then transmits to the market. This approach has limited direct impact on banks but clearly signals the central bank’s policy stance.

Key Differences Between Rate Hikes and Cuts

Units of Measurement for Rate Hikes

Understanding the magnitude of rate hikes requires familiarity with some technical terms:

• Basis points (bps): 0.01%. For example, 50 bps equals 0.5% (0.01% × 50).
• Half a basis point hike: An increase of 12.5 bps, equivalent to 0.125%.
• One basis point hike: An increase of 25 bps, equivalent to 0.25%.

For example, during multiple rate hikes in 2022, the Fed raised rates by 3 basis points each in June, July, September, and November, totaling a 0.75% increase (75 bps). Using this terminology, market participants can precisely understand the specific magnitude of rate hikes.

Why Do Central Banks Raise Interest Rates?

The fundamental purpose of a rate hike is to regulate the economy, keeping it in a healthy state. When the economy overheats or inflation spirals out of control, raising interest rates becomes a necessary policy tool.

How Rate Hikes Combat Inflation

Inflation refers to rising prices leading to a decline in purchasing power. For example, last year an apple cost $1, but due to severe inflation, it rose to $2 this year. If wages stay the same, our real purchasing power drops by 50%. Severe inflation weakens the vitality of the entire economy.

The logic of raising interest rates to fight inflation is simple: when loan interest rates increase from 1% to 5%, the annual interest expense on a $1 million loan rises from $10,000 to $50,000. High interest costs discourage borrowing and consumption, prompting people to deposit more money in banks to earn interest.

As a result, market demand decreases, goods pile up, and companies are forced to lower prices to stimulate sales. Demand and prices both decline, ultimately suppressing inflation. However, this process also leads to reduced production and hiring, rising unemployment, slowing economic growth, and potentially triggering a recession.

Timing and Effects of Rate Cuts

When the economy falls into recession, people are generally reluctant to spend. Central banks stimulate the economy by cutting interest rates—bringing loan rates down to near zero or even below. At this point, borrowing costs are minimal, and deposit returns are very low. People and businesses are more inclined to spend rather than save, increasing demand and driving hiring and growth.

In 2020, amid the COVID-19 pandemic, the U.S. unemployment rate surged, and the Fed quickly lowered the federal funds rate to 0%–0.25%, stimulating consumption. Within two months, the economy began to recover and grow again.

Factors Influencing Central Bank Rate Hike Decisions

Short-term factors: Economic conditions

The Federal Open Market Committee (FOMC) regularly assesses economic data to decide whether to adjust the overnight borrowing rate and money supply. When the economy overheats and growth is too rapid, they raise rates; when the economy is weak, they lower rates.

Medium-term factors: Inflation rate

When inflation is high, central banks raise the benchmark rate to cool down the economy. Recently, U.S. inflation surged, prompting the FOMC to decide on rate hikes to increase borrowing costs, encouraging funds to flow into savings rather than consumption and investment, thus cooling demand.

Long-term factors: Market demand

Long-term interest rates (such as the 10-year government bond yield) are mainly determined by market supply and demand, not the central bank’s overnight rate. When demand for government bonds declines, yields rise; when demand increases, yields fall. Many credit card, auto loan, and mortgage rates are linked to government bond yields.

Multi-faceted Effects of Rate Hikes

Economic activity slowdown

After a rate hike, high borrowing costs discourage consumers and businesses from taking loans to buy homes, cars, and other big-ticket items. Reduced consumption forces companies to cut expenses, delay equipment upgrades and expansion, and even lay off workers. Economic growth slows, competition intensifies, and prices are forced downward—this is the mechanism by which rate hikes curb inflation.

Market volatility

Rising rates lower corporate profit expectations, leading to falling stock prices. High-growth companies are hit hardest because they rely on low-cost financing to sustain growth. Conversely, the bond market becomes more attractive—bond prices fall but yields rise, making fixed-income investments safer choices.

Foreign exchange market trends

When rates rise, investors shift toward bonds, savings, and high-yield currencies seeking higher returns. This increases demand for the currency of the rate-hiking country, causing the exchange rate to appreciate. During the significant rate hikes in 2022, the USD appreciated against the TWD, clearly demonstrating this effect.

Taiwan’s Rate Hike History

Taiwan’s central bank has raised interest rates in recent years as follows:

After the COVID-19 pandemic, global inflation rose, and Taiwan was no exception. The Consumer Price Index (CPI) climbed to a near ten-year high in mid-2022. To control inflation, Taiwan’s central bank increased rates by a total of 2.5 basis points in 2022. Despite uncertain international trade prospects, inflation remained above 2%, prompting continued rate hikes, including another 0.5 basis point increase in March 2023.

The Evolution of U.S. Rate Hikes

The U.S. Federal Reserve’s rate hike path began in mid-2022. In June 2022, with CPI reaching a 40-year high, the Fed started large-scale rate increases. Over the past year, the federal funds rate has risen by nearly 5%. Market expectations suggest that rates may still see small increases in the near future.

This contrasts sharply with the previous easing cycle. In 2019, due to trade tensions between the U.S. and China, the Fed cut rates three times by 1 basis point each. After the outbreak of COVID-19 in 2020, the Fed cut rates more aggressively—once by 2 basis points, then by 4 basis points—ultimately bringing rates down to 0%–0.25%, providing strong support for the U.S. economic recovery in 2020–2021.

Japan’s Divergent Path

Unlike the U.S. and Taiwan, Japan has long adopted low or even negative interest rate policies to stimulate its economy. It wasn’t until late 2022 that the Bank of Japan (BOJ) first adjusted its yield curve control (YCC), widening the yield band from ±0.25% to ±0.5%. This effectively represents Japan’s version of a “de facto rate hike,” signaling a shift from quantitative easing toward moderate tightening. This move also impacted the forex market, with the yen appreciating significantly against the dollar.

Investment Strategies in a Rate Hike Environment

Selected Stock Investments

Legendary investor Warren Buffett believes that a high-interest-rate environment is a good time to buy quality stocks. Although rate hikes may temporarily depress stock prices, once rates eventually fall, stocks purchased during high-rate periods can experience substantial appreciation. Historical data supports this view—over the past 20 years, two Fed rate hike cycles (2007 and 2019) were followed by significant stock market rallies.

Focus on High-Dividend Stocks

During rate hikes, high-dividend stocks become safe havens. Companies with strong dividend-paying ability tend to have stable long-term profitability and are attractive investment targets. Compared to stock price volatility during rate increases, dividends remain relatively stable, allowing investors to receive regular fixed income. High-dividend strategies perform well during rate hike cycles.

Seize the Opportunity of Dollar Appreciation

As the U.S. raises rates, the dollar tends to strengthen against other currencies. Although other countries also adopt monetary tightening, the magnitude of U.S. rate hikes often surpasses them, leading to a noticeable appreciation of the dollar. When U.S. rate hikes exceed those of major economies, the value of dollar assets becomes more attractive, and investors can consider increasing their dollar exposure.

Reassess Bond Investments

In a rising rate environment, bond prices fall but yields rise, making bonds more attractive to income-focused investors. Traditionally, holding bonds during rate hikes is not recommended, but when yields reach attractive levels, new investments can secure higher returns.

Core Summary

Rate hikes are an essential tool for central banks to regulate the economy. The core meaning of a rate hike is to curb excessive consumption and speculation by increasing borrowing costs, thereby controlling inflation. Although mechanisms differ across countries, the goal remains consistent.

From an economic cycle perspective, rate hikes often signal an overheating economy and tend to suppress growth in the short term; however, in the long run, controlling inflation lays the foundation for stable economic growth. Investors should recognize that rate hikes are not necessarily an investment taboo but rather an opportunity for strategic portfolio adjustments—selecting quality stocks, focusing on high-dividend assets, and considering forex allocations can all yield returns in a rising rate environment. Understanding the meaning of rate hikes and grasping their rhythm are key to navigating the ever-changing financial markets with confidence.