Navigating the Federal Rate Hike
Jerome Powell, chair of the United States Federal Reserve, holding press conference
After the decision to raise interest rates during the recent FOMC meeting, the Fed should revisit its rate hike strategy at such a juncture. The Federal Reserve’s recent decision to raise interest rates has sparked a flurry of debate and discussion among economists, policymakers, and the general public. While navigating federal rate hikes, it is important to recognize that the Fed’s actions are aimed at maintaining a delicate balance between growth and stability in the economy.
Before delving into specifics of rate hikes, it is important to establish some context regarding the Federal Reserve, often referred to as “The Fed”, and the profound impact their decisions wield on our economy. The Federal Reserve is the most influential economic institution in the United States. Their purview includes regulation of financial markets, oversight of money supply and, notably, setting interest rates. The Federal Open Market Committee (FOMC) is a committee within the Federal Reserve System that plays this crucial role in U.S monetary policy. They convene eight times per year to make regular decisions on interest rates. rates.
Interest rates are used as a tool to maintain price stability, maximize employment and promote economic growth. Over the past few years, the Fed has maintained historically low rates to allow the U.S. to bounce back from the unprecedented challenges the country faced during the COVID-19 pandemic. In addition, they implemented large-scale asset purchases, known as quantitative easing, without sufficient fiscal report. Quantitative easing is a monetary policy strategy where the central bank purchases securities to increase the money supply and reduce interest rates. This additional assistance brought forth its own challenges, including rising inflation. In efforts to rebound from the post pandemic inflationary economy, the Fed was forced to reevaluate their strategy and start increasing interest rates.
Inflation can erode the purchasing power of consumers and create economic uncertainty. As the prices of goods and services rise, segments of the population are “priced out” for the ability to afford those essential goods and services. Moderate inflation is typically indicative of a robust economy, however, high inflation – especially for a prolonged amount of time -- can adversely impact both businesses and consumers. The Federal Reserve’s objective in raising interest rates is to temper a heated economy and alleviate any burden of inflationary pressures.
In its ongoing commitment to combat inflation in the U.S. economy, the Federal Reserve has incrementally raised interest rates throughout the year, with the current rate sitting at 5.5%. This marks the highest level in over two decades, the last hike being 6.5% in 2000. By raising interest rates, the Fed hopes to make borrowing and investing more expensive, therefore curbing the overall demand for goods and services in the economy. The Fed’s decision to raise rates is part of a broader strategy in ensuring that our economy can get back on track. This strategy is suitable for the current state because, as interest rates increase, the prices of goods will rise, leading to a decrease in demand. Eventually, this will reduce the price of everyday goods and demand will be more in line with supply.
Conversely, higher interest can impede economic growth, posing a challenge to the path of recovery. Businesses will bear the brunt of this impact, as they often rely on low borrowing costs to fuel expansion, create jobs, and innovate. Higher interest rates are bound to dampen both investment and consumption, with potential rippling effects extending to the realm of innovation. The Fed depends on data sourced by public and private institutions to look at various economic indicators such as the supply and demand for loans and credit. to make their decision to raise or lower rates therefore, future rate hikes will be contingent on how the economy evolves.
Perhaps the most intriguing statistic lies in the correlation between the highest interest rates seen in over two decades and a record low unemployment rate of 3.8%. This might seem counterintuitive because, traditionally, when interest rates rise sharply, the cost of labor rises. There are several reasons why this may occur. Firstly, there has been a surge in the labor force supply, resulting in a greater number of job seekers entering the market. At the same time, businesses have slowed their hiring, rather than implementing job cuts, despite a reduced demand for workers. The inverse relationship between the decreasing unemployment rate and increasing interest rates can be explained by the Phillips curve. While a low unemployment rate sounds like a positive for the economy, it can radically drive inflation up. Though the validity of the Phillips curve tends to fluctuate, it is proving to accurately reflect our current state.
In our current state, interest rates continue to rise with no end in sight. This is largely because the U.S. economy has demonstrated greater resiliency than expected toward increased rates compared to previous years. While housing activity has declined sharply, many other facets of the economy remain relatively unaffected. Excessive household savings are currently providing temporary cushioning from higher interest rates, but these savings will reduce over time, and will pose a challenge to society.
The Federal Reserve’s choice to raise interest rates is a decision made seriously, driven by the need to tackle the rise in inflation and promote economic prosperity. It is imperative for the Fed to articulate their intentions, both clearly and transparently, to avoid abrupt market reactions. Given the dynamic nature of our economy, where inflationary pressures will eventually subside, the Fed should remain open to reconsidering their strategy for raising interest rates. While the current times present formidable challenges and these rate hikes pose short-term challenges, they are essential for the long-term health of our economy. The Fed should continue raising interest rates gradually and expanding on the recent decision in the July 26th FOMC meeting.