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Why does the federal raising interest rates actually have an effect on the economy? The typical answer is that it reduces money supply by incentivizing saving and increasing cost of loans.

But couldn't market participants just react by adjusting FX rates, inflation, etc. by the appropriate amount? Then even though the money supply is reduced, the real rates are unchanged, resulting in no net effect. What are the factors preventing this from actually happening?

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The typical answer is that it reduces money supply by incentivizing saving and increasing cost of loans.

This is backwards. The Federal Reserve (the United States' central bank) sets a target for the federal funds rate. The rate itself is a weighted average based on market activity. The Fed encourages the average rate to match the target by buying and selling bonds in what are called open market operations. Buying bonds puts money into circulation, increasing the money supply. Selling bonds takes money out of circulation. The Fed changes the money supply to change the interest rate, not the other way around.

But couldn't market participants just react by adjusting FX rates, inflation, etc. by the appropriate amount?

Only if all (or even most) of the participants worked together. If only one or a small portion of participants attempt this, then it creates arbitrage opportunities for the remainder. Currency exchange rates and inflation are both set based on market actions. They aren't so easy to adjust.

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I guess whats missing from your question is the unpacking of what you mean by "work"? To address that, let's talk about the multiple objectives the Fed is trying to meet in raising those interest rates:

  1. It's attempting to preserve its credibility, which is threatened by a zero-interest-rate forever policy.

  2. It's attempting to maintain its political capital, which is eroding as even the mainstream media has accepted the reality that Fed policy has enriched the already-wealthy at the expense of everyone else.

  3. It's attempting to "normalize" interest rates without killing its favorite child, the stock market.

  4. It's attempting to raise rates without upsetting the fragile global currency/debt shopping cart.

Now, the raising of the interest rate will probably dampen carry trades. Carry trades are speculations based on borrowing U.S. dollars and investing that borrowed money in higher-yielding and extremely risky emerging markets.

Those emerging market bets are denominated in the home-country currency, and as those currencies decline against the USD, the carry trade's gains are offset by foreign exchange (FX) losses.

Again, a lot of how you understand and/or interpret the raising of interest rates working is dependent on what role you play in this whole thing. Typically, the raising of interest rates tends to strengthen the U.S. dollar, anytime the U.S. dollar is strengthened, it ends up being to the detriment of U.S. global corporations, please note the term global.

I know it is our habit as Americans to assume that Direct TV, Blackberry and all these wonderful products are only available to us, made by us, sold to us. Everyone and their mother in Caracas, Venezuela has Direct TV and a Blackberry. So these U.S. corporations are doing business globally and so strengthening of our currency typically translates to a loss for them.

As the dollar strengthens, the $7 trillion in dollar-denominated debt in emerging markets increases in value relative to depreciating local currencies.

The real dilemma here, which again as Americans we never think about, because the Fed is an American institution, the dollar is an American currency, is that the Fed has two roles to play. It is expected to keep its local economy stable and strong, but its also expected to satisfy the world with dollars.

Another loser of raising interest rates, aside from U.S. global corporations is China. Increase in yields will push down the value of existing Treasury bonds that China holds, so China's still-vast hoard of Treasuries will lose value as the coupon rate rises.

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couldn't market participants just react by adjusting FX rates, inflation, etc. by the appropriate amount?

Exchange rates actually adjust in a way that ends up precluding arbitrage opportunities.

Although a central bank might aim at a certain level of inflation, the exchange rate and inflation are not variables that the central bank can control. Instead, the central bank's primary tool to influence these and other variables is the interest rate.

A central bank can intervene by using its reserves of foreign currencies for the purpose of restoring stability of the local currency, but the bank's ability to do so is limited to the amount of reserves it is willing or able to sacrifice. By contrast, the central bank is not "physically" constrained when determining an interest rate. In other words, interest rates entail a degree of freedom that a central bank does not have with exchange rates.

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