Inflation. The word used by every person you know. Because they all believe themselves to be experts in finance. Don’t they?
Central Banks are able to control inflation by controlling the supply of money. If they can. This happens by increasing the cost incurred by the banks to borrow money from the central bank. This is what people have been hearing about lately out of the U.S.: the Federal Interest Rate. When the cost of borrowing for banks becomes higher, their cost of lending to the public increases, they will borrow and lend less, and so the supply of money does not out outweigh the supply of goods. At least not enough to shoot inflation up the roof. This may not really apply in Dubai, but in the U.S. it’s a totally different story.
People ask us why are the stock market, and the value of the U.S. dollar affected by the “Fed Rate”. This is actually interesting. It’s called The Ripple Effect:
The Fed (or central bank) increases the cost of borrowing for the banks. The banks increase the cost of lending, which affects “balloon-based” loans, and loans with variable interest rates, as well as credit cards charges… This decreases the amount of money customers can spend, and so they will have less Discretionary or Disposable Income (which is meant for luxury or leisure spending…), which will affect revenues and profits of businesses. Businesses will then declare less earnings, which will affect the price of their stock.
The same goes for companies, whose cost of borrowing will be higher, they will expand less, and spend less, which will surely affect their profit.
And there you have it. A small increase in the Fed or Central Interest Rate, and inflation goes down, but the stock market along with it. This in turn affects the value of the U.S. Dollar (or local currency), which would probably affect any forex pair the USD is involved in. Like Euro/USD. And then you might also hear that “the Euro is up”, although nothing particularly interesting might have happened in Europe.
If you think about the above a bit more, you can imagine more ripple effects, not only in the U.S., but also in Europe, Japan… all related to the U.S. Federal Rate.