The Federal Reserve (FED) has approved the largest interest rate increase since 1994 and signaled it would continue to raise interest rates over the next few months to contain the highest inflation the U.S. economy has seen in 40 years.
“I do not expect moves of this size to be common,” said Jerome Powell, the FED’s chairman, during the press conference following the announcement of the decision by the central bank’s Board of Governors, which defines the next steps in the management of U.S. monetary policy.
Even with an annual inflation rate of 8.6%, Powell affirmed that the Central Bank’s goal remains to reach an inflation rate of 2% in the long term.
Despite external factors such as the war in Ukraine, which has limited vital supplies of commodities such as wheat grains, or oil following the imposition of sanctions on Russia, core inflation—which excludes the cost of more volatile goods and services such as the cost of energy or food—remains around 6%, tripling the Fed’s long-term inflation target of 2%.
The latest inflation report has caused concern among economists, who have seen how the FED’s models have failed to forecast rising prices in recent months.
For some economists, the FED’s decision anticipates a recession in the U.S. economy. In the first quarter of 2022, the economy had negative growth of 1.4%.
The rise in interest rates, at which the Central Bank lends money to commercial banks, increases the cost of credit throughout the economy. In the first quarter of 2022, the economy had negative growth of 1.4 %.
A rise in interest rates almost immediately increases the interest on credit cards and the cost of home or car loans. It also raises the cost of student loans and limits the leverage of companies.
As a result of the FED’s hikes, the mortgage rate in the United States went from 3% in January to 6.13% today. In other words, in less than six months, interest rates on new home loans in America have doubled.
The FED’s dilemma
According to the FED’s own projections, interest rates will rise to 3% by the end of this year. The projections also predict that the interest rate at which the Fed lends to commercial banks will be around 3.75% by the end of 2023.
This is no small increase, as in March FED officials had expected the interest rate to be around 2.5% by 2023. A hike of more than one point in current projections indicates that Fed officials did not expect inflation to persist as it is doing.
To avoid a market crash during the nearly two-year COVID-19 crisis, the FED issued an equivalent of about $5 trillion, coupled with an additional injection of money from the government that went directly into Americans’ pockets. Both administrations injected more than $5.6 trillion into the U.S. economy through three stimulus plans.
In less than two years, more than $10.6 trillion was injected into the economy through different channels, which equates to nearly 50% of U.S. GDP. Trillions of dollars flowed through the markets to restore economic activity.
Although demand and employment eventually revived, the economy may now be too hot, and the rise in prices is no longer “transitory,” as Biden administration officials claimed, and the FED now fears that it has become chronic.
The FED has a difficult task, for although it has the power to influence consumption and hiring, it can do nothing to boost supply which is constrained by the war in Ukraine, the zero COVID-19 policy in China, and the supply chain crisis.
Even if the Central Bank succeeds in partially discouraging demand, the cost may be that the economy enters a recession, with inflation having failed to fall to the FED’s 2% annual target.