Fed Reserve raises interest rate to fight inflation

The US Federal Reserve has raised the bank interest rate from a near-zero level to 0.25 to 0.50 per cent range, for the first time in four years as inflation stubbornly stood at 6.1 per cent. Federal Reserve Chairman Jerome Powell said, “As I looked round the table at today’s meeting, I saw a committee that’s acutely aware of the need to return the economy to price stability and determined to use our tools to do exactly that.” The inflation in the American economy has reached the highest in 40 years.

In the last two years of the pandemic, the Fed brought down the interest rates to keep the economy going and maintain the liquidity in the markets. But as the pandemic seems to taper, the feeling has set in that there is a need to taper the asset buying as well and raise the interest rates.

There are two interesting causes behind the inflationary trend prevailing now in the American economy. First, the pent-up savings of the two years of the pandemic has led to spending more than it has been usual. Second, the wage growth, part of the inflationary trend, has grown because of the shortage of labour.

The Fed Reserve plans to raise rates at the rate quarter percentage points in the next six meetings of the Open Market Committee meetings due in the year, and there is even the possibility that the rate hike would not be such an incremental affair either. On Wednesday, the rate hike was voted 8-1, and the dissenting vote was for increasing the rate by half percentage points. So, there is a possibility that in the meeting at the beginning of May, the rate hike would be higher. The Fed Reserve wants to walk the tightrope of not allowing the rate hike to either push the economy into a recession by its control of money supply, nor allow a runaway inflation.

The war in Ukraine and the economic sanctions against Russia, it is feared, could raise the oil and food prices, and that the rate high could be ineffective against this development in global commodity markets. It is not clear how long the war in Ukraine would continue, and though there are signs of a compromise being worked out between Ukraine and Russia, how long the Western countries would take to withdraw the sanctions.

American policymakers, especially at the Fed Reserve, are concerned about the persisting inflation, though they were optimistic a few months ago that it would decline as the economy picks up momentum. But that has not happened.

The central bankers as well as other economic experts admit that the Fed Reserve has not faced the inflation challenge since the 1970s and 1980s, and they are quite uncertain whether the rate hike would be the best tool to handle it. It is expected that the bank interest rate should reach about 2.5 per cent by the end of 2023 and even go up to three per cent after that.

In many ways, the American, as well as the global, economy, has not recovered from the meltdown of the financial institutions in America in 2008 arising out of the sub-prime mortgage crisis, and the interest rates had hovered round zero since then. The spike in inflation through 2021 has made everyone sit up, and there were signs of alarm.

The Bank of England too raised the bank interest rate on Thursday by 0.75 per cent, but the approach is slightly different. The assumption is that a moderate rise in interest rate should be able to bring stability to the economy and there is no need to press the panic button as it were.