Macro Overview – Interest Rates

US interest rates rise

US Federal fund rates have finally risen. A Kevin Warsh that once appeared tractable can now bathe in the glory of impartiality. Warsh and his colleagues voted unanimously on Wednesday to raise the federal target range to 3.75% – 4% – the first increase since July 2023, when the central bank aggressively raised rates in its delayed response to the 2021 inflation surge. Moreover, the committee indicated that more increases are coming: of the 18 Fed officials who submitted forecasts, 16 expect at least one additional quarter-point increase in 2026.

Therefore rates effectively stand at 3.88%, but this number is of negligible significance without context. The US has had more than five years of high inflation — the longest bout of inflation since the late 1970s, early 1980s, and it has compounded. In the face of such inflation the Fed has refused to hike rates, and given this refusal is largely attributed to political pressure from a certain President, the Fed credibility as an institution has been under warranted scrutiny. That is until now. Kevin Warsh’s has swooped in, like Van De Ven at the back post for a 96th-minute winner, in his hawkish announcement of a quarter-point rate hike. Easing the nerves of US lenders and, for now, dispelling the thesis that the Fed is one of Trump’s many playground toys.

So what caused such a damning verdict on the need to raise interest rates for the first time in so long? There are two core factors.

1. Inflation

Inevitably, the primary factor is inflation. It’s worth noting that Warsh didn’t directly attribute blame to inflation, but rather he used a euphemism in stating that “geopolitics is part of the picture”. But for ease let’s just read geopolitics as inflation – as the two are largely conflated. Since Warsh’s nomination in January, the conflict between Iran and the US has been hugely significant in driving PCE inflation to 3.7% and CPI 3.4% YoY (almost double its 2% target). Petrol and diesel prices had spiralled out of control – costing American households an extra $108bn since the outbreak of the president’s war (as per a Brown University tracker). Real wages, meanwhile, have budged only 0.1% up between June 2025 and June 2026. Inflation outpacing real wage growth to this extent is a textbook precursor to an affordability crisis; a rate hike was necessary in preventing a further erosion in purchasing power and protecting US citizens. 

One further driver of the rate hike (which many commentators seem to have omitted) is the concern of real interest rates (nominal rates – inflation) turning negative. Before the hike, the Fed funds rate of 3.50%-3.75% against 3.4% CPI left a real rate of only about 0.1%-0.35%. This is quite a thin margin, meaning savers were only fractionally profitable. However, a similar inflation print to the 0.4% jump between July and August could have tipped that margin below zero, at which point a consumer saving at 3.6% interest would effectively be repaid in dollars worth less than those lent out. The Fed would have been cautious to let a consequent dynamic of limited saving and speculative spending play out thus providing further explanation behind a rate hike.

2. Growth

Warsh also noted that ‘the hyperscalers are raising money in the markets, so there is real competition for capital as well’. What he alludes to here is that growth in the US economy has also contributed to the hike in nominal rates. Specifically the Fed considers a concept called ‘r-star’ when deciding adjustments to the interest rate. R-star is the rate at which the economy is neither being stimulated nor restrained by monetary policy, and is affected by how much demand there is for capital versus how much supply of funds exist. The continued surge in borrowing to fund runaway capex from AI behemoths has pushed up r-star, meaning the Fed’s old rate of 3.50%-3.75% was less restrictive on the economy than it looked (it was low relative to a higher neutral rate) and needed to be to control inflation. In summary AI-driven growth in the US economy has also contributed to the September rate hike, albeit being less of a factor than a tool for the Fed to establish that inflation was not being controlled adequately.

I would argue there are 3 key stakeholders who have been impacted by the rise in the Federal funds rate:

A) The US Bond market:

The clearest and fastest reaction to the rate hike was in the bond market. Two-year yields rose 0.07 percentage points to 4.74% (before easing to 4.71%) because two-year bonds are priced heavily on what investors expect the Fed to do over the next couple of years; a hike signals more likely short-term rate rises ahead, so existing two-year bonds – locked in at the old, now-comparatively-low rate –  become less attractive and get sold off, thus pushing yields up. Thirty-year yields dipped to 5.35%, as long-dated bonds are driven almost entirely by inflation projection. Therefore the rise in the demand/price of thirty-years indicates that investors believe the rate hike will begin to bring inflation back to target over the long run. Finally as expected the dollar strengthened 0.7% against a basket of currencies, as the higher rates pulled in more foreign capital seeking better returns.

B) The broader US economy

Those who were worst affected were small and medium-sized enterprises (SMEs) given they rely on short-term bank loans that are priced directly off the Fed funds rate, as a result facing an immediate rise in borrowing costs. There are also other agents in the economy who’s borrowing is tied closely to the Fed funds rate, such as credit card holders (facing a $1.38 increase per month on a typical 6,600 balance) and home equity borrowers. Mortgage borrowers were not confronted with much change in the immediate aftermath of the rate announcement given mortgages track the 10-year treasury yield and that yield had already priced in hike expectations, however they did reach an intraday high of 5.04% the right before the decision (later slipping down to 4.93%). Beyond these rather unfortunate segments, the broader economy was left largely unscathed, albeit the aforementioned AI behemoths now face a very interesting decision regarding future capex spending decisions: given borrowing is now pricier across the board, perhaps they will become more controlled on the scale of infrastructure spending. Though we can only wait and see.

C) Me and you (or anyone else from the UK):

Although we are not American, we are still victim to the aftershock of a US rate hike. The UK is primarily affected through currency and import costs rather than any direct policy link. Sterling slid to around seven-week lows against the dollar (roughly 1.337-1.35) right before the hike announcement. This is also in part a product of the Bank of England holding its own base rate at 3.75% for a sixth straight meeting even with UK inflation at 3.1% – widening the gap between UK and US returns and making the pound less attractive to hold. In turn a weaker pound makes dollar-priced imports – oil chief among them – more expensive at exactly the moment fuel costs are already elevated from Middle East-linked disruption, adding a fresh layer of imported inflation the BoE now has to weigh alongside its own domestic price pressures. It is no surprise then that markets increasingly expecting the BoE to hike rates at its own November meeting instead.

My thoughts

As an investor in one too many Mag 7 companies, I am hopeful that this rate hike may benefit my portfolio down the line (NFA). Indeed shareholders may begin to notice a rise in forward-FCF if certain companies decide to reduce the pace of infrastructure spending in line with higher borrowing costs. I can hear the naysayers arguing that companies like Amazon and Meta could yet continue to plough ahead with runaway capex funded by alternative sources, however I would argue that there aren’t many left! As I have discussed in articles of the past, US lenders are largely ‘tapped out’, and European lenders the same, so it would be hard to continue sourcing capital at a rate lower than the new Federal funds rate. Though we shall see.

Slightly off-key, but the idea of a ‘disconnect’ kept slapping me in the face as I wrote this article. There is a humorous disconnect between Trump’s outlined intentions at the start of his second term (keeping inflation low, keeping interest rates low) and his policies which have quite literally had the opposite effect (higher inflation, subsequent hike in rates). Though there is also a notable disconnect that the Fed is navigating: it hike rates in an economy where some businesses are already reporting softer demand, and where one of the biggest inflation drivers – Middle East-linked oil prices – isn’t something a higher policy rate can directly fix, meaning the hike raises the cost of doing business without necessarily addressing the sources of inflation it’s aimed at. Trump has proposed a suspension of the federal gas tax, but this seems like a temporary fix which will cost the government much needed revenue – a very sour sight for 30-year treasury holders. Perhaps a targeted rebate/subsidy for lower-income families would help cushion those hit hardest by gas-related costs, without propping up demand the way a blanket subsidy would? Or they could listen to critics who propose hitting oil firms with a windfall tax on the excess profits they continue to make? Who knows. Certainly America’s inflation problems don’t end here. But maybe they end next year as the Fed has projected (synonymous with the word hoped).