The Federal Reserve boosted its benchmark rate by 0.5 percentage points recently. In the nearly 22 years since George W. Bush was President, the Federal Reserve has never taken such a drastic action. However, in the face of rising inflation in the United States, this step had become necessary.
Jerome Powell, chairman of the Federal Reserve, said, "Inflation is far too high, and we recognise the misery it causes. We are moving swiftly to bring it back down". Since 1981, inflation in the United States has reached an all-time high of 8.4 percent. The increase in inflation is due to increased consumer demand and disruptions in the supply chain. In addition, the Russia-Ukraine conflict has triggered food and oil crises, resulting in higher prices.
Among the consequences will be a rise in borrowing costs for everyone, including credit cards, auto loans, and others. Unfortunately, the Fed does not have the luxury of gradually increasing interest rates. The prices of gasoline and food increased by 48% and 8.8%, respectively.
Typically, a country's central bank will boost interest rates to combat inflation. This encourages individuals to spend less and save more, as the profitability of savings increases as interest rates rise. When individuals begin to save more, money leaves the market and the inflation rate falls. Extremely high or extremely low inflation can harm an economy. As a result, it is essential to keep inflation and interest rates at a modest level, since interest rates play a significant role in maintaining inflation at a moderate level.
With a national debt of over $30 trillion, higher interest rates will increase the government's borrowing and refinancing expenses. Obviously, a decades-long fall in interest rates has benefited the government. As long as inflation is higher than interest rates, the government is gradually taking advantage of inflation by paying down old debts with less valuable currency. This may seem appealing to the government, but it is not attractive to investors who purchase its debt.
Also of worry to economists is the rising labour cost. Therefore, the Fed finds itself in a precarious position between managing inflation and preventing a recession. As interest rates are still historically low, the Fed can raise rates further to combat inflation, but this could produce an economic short circuit in 2023 or 2024, leading to a recession.
Jamie Diamon, chief executive officer of JP Morgan, stated, "The Fed delayed too long to raise interest rates." The Fed was overly enthusiastic about the rate of inflation growth. They believed that inflation would decrease on its own and that the supply chain problem would resolve itself. But this did not happen.
Even if the increase in interest rates produces recession, it may provide an economic shock and cut inflation in the long run. Increasing the cost of borrowing money is one of the Fed's strategies for reducing demand. However, interest rates are still historically low, so the central bank will have to move rapidly to catch up; another half-point hike is probable at the June Fed meeting.
The Fed last raised rates aggressively in early 2000 to 6.5% but was forced to backtrack just seven months later. Due to a pre-existing recession and the terrorist attacks of September 11, 2001, the Fed swiftly lowered interest rates, reducing the federal funds rate below 1 percent by mid-2003, shortly after the Iraq invasion. Some analysts are afraid that the Fed may confront the same conundrum as in the past: failing to move when inflation was skyrocketing and then tightening when economic growth slowed.