8 min readThe Federal Reserve, the US central bank, is responsible for maintaining stability in the country’s financial system. The primary tool at its disposal is interest rates - in short, it lowers rates to stimulate the economy and raises them to cool it down. Given the US dominance of global finance, changes to its monetary policy can significantly impact both traditional and alternative asset classes, so this article explains how the Fed manages rates and explores their relationship with bitcoin.
Understanding Federal interest rates
The Fed manages two interest rates: the Fed Funds rate and the Discount rate. The Fed Funds rate is the interest banks pay each other to borrow overnight if they need to top up their reserves. Until 2020, banks had to hold 10% of customer deposits in reserve, and they could lend the rest to retail and corporate customers. For example, if a bank had $100 million on deposit, it had to keep $10 million in reserve and it could lend the remaining $90 million. However, the Fed lowered the reserve rate to 0% in March 2020 to stimulate the domestic economy in response to the Covid pandemic.
The Federal Open Market Committee (FOMC) sets the Fed Funds rate. It establishes a target range, which it maintains using tools like quantitative easing, while supply and demand among banks fixes the exact rate. The FOMC holds eight meetings per year (the next one is due at the end of July), and traders monitor the minutes closely for hints about changes to monetary policy that could affect the markets.
The Discount rate is the interest paid by banks that borrow from the Fed overnight to meet short-term liquidity needs. There are three different Discount rates:
Primary credit (5.5%)- extended to financially sound banks.
Secondary credit (6.0%)- for banks that don’t qualify for primary credit.
Seasonal credit (5.35%)- offered to smaller banks to help manage seasonal swings in deposits and loans.
The Fed uses interest rates to control the amount of money flowing through the US financial system. If the country is experiencing an economic slowdown, lowering rates makes it cheaper for banks to borrow from the Fed, and they can offer more affordable loans, which should boost spending and stimulate the economy. Raising rates has the opposite effect, as experienced in 2023 when inflation soared due to measures put in place during the pandemic and disruption to supply chains caused by Russia’s invasion of Ukraine.
Deciphering Bitcoin's DNA
Satoshi Nakamoto, the pseudonymous founder, designed bitcoin to be decentralised, meaning it isn’t controlled by a central authority. The blockchain serving as the underlying infrastructure is a distributed ledger, so it’s stored on thousands of computers, known as nodes, around the world. For a single entity to hijack the network, it would need to control 51% of the hash rate, the computational power used by miners to validate transactions. The estimated cost of launching a ‘51% attack’, at $1.5 million per hour, makes it prohibitively expensive.
Satoshi also capped the total supply of bitcoin at 21 million to make it anti-inflationary (19.7 million are in circulation as of [date]). New coins are issued in the form of block rewards (currently 3.125 btc) paid to miners, but it halves roughly every four years. The latest ‘halving’ took place in May, and the last bitcoin is expected to be mined in 2140. Incidentally, this scarcity has driven the ‘digital gold’ narrative.
While Satoshi intended for bitcoin to be used as a medium of exchange, it has gained broad traction, particularly in developed countries, as an asset class. This status was boosted by the Securities and Exchange Commission when it approved spot bitcoin exchange-traded funds (ETFs) in early 2024.
Like any asset, bitcoin’s price is subject to various forces:
Market sentiment - investors let emotions such as fear or greed guide their decisions, which explains why media coverage can strongly influence bitcoin’s price.
Regulation - As a relatively new asset class, the global rules governing crypto are inconsistent and constantly evolving. Greater regulatory clarity is generally positive, as demonstrated by the launch of spot ETFs.
Technology - blockchain is also a new technology, so innovations or vulnerabilities can impact market sentiment.
Institutional adoption - Inflows from institutional investors, which have accelerated since spot bitcoin ETFs started trading, are bullish due to the sheer amount of capital they control.
The Intriguing Interplay
Macroeconomic forces, including interest rates, also influence bitcoin’s price. Bitcoin’s volatility means it tends to respond to rate changes similarly to higher-risk asset classes like shares. Bonds, on the other hand, are considered among the safest assets, particularly those issued by Western governments.
Bitcoin generally benefits from lower rates for several reasons:
Investors seek returns from riskier assets when the income paid by bonds and savings accounts falls.
The money supply increases and some of it ends up in the markets.
Lower rates imply the Fed is trying to stimulate the economy which boosts riskier assets like crypto.
Higher rates have the opposite effect- bonds become more attractive, less money flows through the financial system, and the Fed is usually attempting to tame inflation or slow down the economy.
The best way to illustrate the relationship between interest rates and bitcoin is by exploring the impact of rate changes over the last several years. After remaining at record lows since the financial crisis, the Fed started raising rates at the end of 2016 and continued until spring 2019. This tightening of monetary policy coincided with a collapse in bitcoin from $16,000 in December 2017 to $3,500 at the start of 2019. The following year, when rates fell in response to the pandemic, bitcoin rallied, eventually hitting a new peak of more than $65,000 in November 2021. Then when rates rose to 5.5% in spring 2022 (the highest level since 2007) to combat inflation, bitcoin again moved in the opposite direction, dropping from nearly $46,000 to a low of $16,500. The bull market that started in autumn 2023 may seem to have bucked the trend, given rates have remained elevated, but other catalysts have arguably supplanted macroeconomic forces, specifically the launch of spot bitcoin ETFs and the latest halving.
Conclusion
Interest rates are one of the main tools used by the Federal Reserve to stabilise the US financial system. It achieves this goal by managing the Fed Funds and Discount rates.
Satoshi Nakamoto designed bitcoin to avoid some of the problems experienced with fiat currencies when central banks intervene with monetary policies. Bitcoin is decentralised, which means no central authority controls it, and the total circulation is capped at 21 million.
The relationship between bitcoin and interest rates is generally inverse- when rates fall, bitcoin tends to rise, and vice versa. This pattern appeared to have failed in 2023, although other catalysts have driven the latest bull market.
