The U.S. Federal Reserve (Fed) hiked its interest rate by a quarter-percentage point – for the first time in more than three years – aimed at tempering an overheated economy, reining in inflation and curbing borrowing. This move will bring the rate now into a range of 0.25%-0.5%.
Rising energy, food and housing prices pushed U.S. inflation to jump 7.9% over the past year (February 2021 to February 2022), the worst in four decades. Moving to curtail inflation, the Fed tightened its monetary policy by raising its key short-term interest rate and penciled in six more increases this year, pointing to a consensus funds rate of 1.9% by year’s end.
Fed kept rates near-zero to weather the pandemic
The Fed raised interest rates on Wednesday, almost two years after it slashed rates to near-zero levels and began buying billions of dollars of Treasury bonds and mortgage-backed securities (MBS). During those two years, it also focused on lending (at historically low borrowing rates) to support households, employers, financial market participants, and state and local governments to stimulate the economy through the COVID-19 economic downturn.
Furthermore, the vaccines and the stimulus payments provided to U.S. lower income and middle income households encouraged spending and helped demand rebound, but supply struggled to keep up because of the pandemic-driven global supply chain bottlenecks, production backlogs and labour shortages. These factors pushed the cost of virtually everything higher, fuelling inflation.
Despite aggressive stance, inflation will not immediately abate
The U.S. central bank’s response to combat inflation is more aggressive than the Fed’s last round of projections (from December) that had predicted only three rate hikes in 2022.
The Fed, however, has warned that inflation will not immediately abate in response to the interest rate hike. Economic uncertainty remains.
“The invasion of Ukraine by Russia is causing tremendous human and economic hardship. The implications for the U.S. economy are highly uncertain, but in the near term the invasion and related events are likely to create additional upward pressure on inflation and weigh on economic activity,” the Fed said in its Federal Open Market Committee (FOMC) statement.
The Fed estimates inflation to remain elevated, ending the year at 4.3% – well above its 2% annual target – before easing to 2.7% in 2023. The U.S. central bank did lower its GDP outlook for the year (slower economic growth), from 4% at its last meeting in December to 2.8%.
Impact of the rate hike
The rate hike is expected to make borrowing pricier and credit more expensive – everything from corporate loans to mortgage payments – thus decreasing purchasing power and demand. The slackening demand will cool off home prices that have skyrocketed during COVID, moderate spending (less money circulating in the economy) and reduce inflation over time.
The impact of the increase in interest rates can carve into corporate profitability. Added financing costs may result in lower revenues and dissuade companies across various sectors from commencing new projects or growing their businesses because of the inability to access affordable capital.
The interest rate change will encourage savings. Yields on CDs and savings accounts will rise, but the gains are expected to lag the interest rate increases by weeks, if not months. Also, the higher rates to savers won’t offset inflation that has weakened how far those extra dollars will go.
Fed’s tricky balancing act
The U.S. central bank is walking a tight rope between inflation and recession. Under Chairman Jerome Powell, it is hoping that the rate hikes will bring inflation back in line with its mandate and achieve its intended objective – raising borrowing costs enough to maximize employment (allow the labour market to grow), slow economic growth and tame high inflation, yet do so without driving the economy into recession.
“We’re acutely aware of the need to restore price stability,” Powell said. "In fact, it’s a precondition for achieving the kind of labor market that we want. You can’t have maximum employment for any sustained period without price stability.”
The FOMC also expects to begin reducing its holdings of Treasury securities, agency debt and agency mortgage-backed securities at a coming meeting, a move that will further counter inflation. The Fed has also made plans to tighten the money supply by shrinking its $9 trillion balance sheet. However, the Fed’s game plan to contract monetary policy and lessen economic activity through its first interest rate hike since 2018 may face challenges.
Fed’s challenges and uncertainties
The Russian-Ukraine conflict and associated oil, gas, wheat and other commodities price increases (commodities prices have pulled back from their recent highs, but uncertainty prevails), and China’s lockdowns to contain fresh COVID-19 outbreaks may snarl already frayed supply chains and add inflationary pressures on the global economy. A lot will depend upon what happens with the financial markets (stocks, bonds, currencies, commodities and derivatives), access to bank credit, consumer sentiment, corporate earnings, and if the Ukraine war escalates.
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