The Chairman of the Fed in his statement has hinted that another interest rate hike is on the horizon. The possible impact on the economy as a whole has investors & economists paying close attention to this development. The Federal Reserve is trying to find a middle ground between the need for continued economic growth & concerns about inflation & other economic pressures, by raising the interest rates. This article “Interest Rate Will Raise Again” examines how this might affect individuals & businesses in the United States.
Introduction
On Wednesday (i.e. 8th March 2023), Federal Reserve Chair Jerome Powell returned to Capitol Hill for his second-day testimony to Congress (henceforth lawmakers). But, on Tuesday (i.e. 7th March 2023), he stated that the Central Bank will reflect raising interest rates by a larger than 50 percentage point (i.e. ½ percentage point) later this month.
Mr. Powell stated before the Committee on Banking, Housing, and Urban Affairs, US Senate, on Tuesday (i.e. 7th March 2023), that the Federal Reserve is likely to increase the interest rates higher this year than earlier to control inflation. Many Analysts, Economists and Investors expected that the Federal Reserve will increase the interest rate in the range of 5% to 5.5% this year and will keep unchanged till 2024.
Summary/ Highlight on Fed Chair’s Statement including Current Economic Situation and Outlook
Mr. Powell in his testimony to the Senate Banking Committee explained the Current Economic Situation and Outlook as follows:
The January Data on Inflation, manufacturing production, employment and consumer spending is showing softening trends to a month ago. This reversal trend is due to unseasonably warm weather in January in many parts of the country.
The total Personal Consumption Expenditures (PCE) prices, a 12-month change, slowed from its peak of 7% in June 2022 to 5.4% in January 2023. This is due to the decline in energy prices and ease of supply chain bottlenecks. The Core PCE Inflation (excluding Food & Energy Prices), over the past 12 months, was 4.7%. Inflation in the core goods sector has fallen as the supply chain bottlenecks have eased along with tighter policy which restrained the demand.
Mr. Powell stated to the Senate Banking Committee that though inflation is coming down in recent months, it is a long way to go to bring it back to the 2% target and the road seems to be bumpy.
Fed Chair told that “…. The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated. If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”
He also said that to restore price stability Federal Reserve may maintain the restrictive stance of monetary policy for some time. Federal Reserve is mainly focused on using its instruments to bring inflation to the targeted goal of 2% along with anchoring the long-term inflation expectations. To achieve stable prices and maximum employment over the long run it is pertinent to restore price stability. The Historical records caution strongly against early loosening policy, therefore, the Fed chair said that the Federal Reserve will stay the course till the job is done.
Mr. Powell stated that Federal Reserve is aware that its actions affect businesses, families and communities across the country. Whatever Federal Reserve does is in service to its public mission and will do everything to achieve Price Stability goals along with maximum-employment.
The uncharacteristic Economic responses/behaviour
There are some uncharacteristic economic behaviour/ responses happening which is making Federal Reserve’s job tougher. Let’s see what they are
By increasing the Interest Rate, the Fed is trying to slow down investment, spending and hiring to control inflation. This increase in interest rates, normally, makes borrowing more expensive and pushes down the prices of assets (like stocks and real estate). The current range of interest rates between 4.5% and 4.75% is the highest since the early 1980s.
An Increase in Interest Rates can slow the economy more instantly whereas credit growth is one of the main factors which drives economic growth. This completely contrasts with stimulus and income, which was the big drivers of the post-pandemic economic recovery.
Normally, the Housing and Auto market sectors are rate-sensitive. This means when Fed increase interest rates the demand for housing and cars/motor vehicles will fall which will, in turn, make the builders and automakers reduce their production which leads to laying off workers. But, at present, the producers/companies are yet to catch up with this scenario. The shortages of materials and workers have made these two sectors, at least for now, more robust to the higher interest rates.
Consumer Spending has increased in recent months. Thanks to an additional boost, in January, from higher Social Security checks (which are indexed to last year’s inflation) and lower gasoline prices. This decline in gasoline prices helped the consumer to balance higher rates on auto loans, mortgages and credit.
Puzzling Labour Market
One of the main worries for the Federal Reserve about Inflation is the Labour Market. Mr. Powell in his statement to the Senate Banking Committee stated that “Despite the slowdown in growth the labour market remains extremely tight.” He stated that the unemployment rate was 3.4% in January 2023 – its lowest level since 1969. Job gains are very strong in January. He observed that the Unemployment insurance claims have remained near historical lows.
In January 2023, the employers added 517,000 jobs – the number which has not only surprised many economists, and analysts, but also even policymakers who were expecting a slowdown. However, the report on February hiring from the Labour Department is due for release on Friday (i.e. 10th March 2023). It is expected that this report may offer clues as to whether January’s data is a one-off instance or a real sign of an accelerating economy.
On Wednesday (i.e. 8th March 2023), the Labour Department released “Job Openings and Labor Turnover – For January”. The report shows that the rate of job openings decreased by 6.5% (10.8 million in numbers). The rate of hires changed a little at 4.5% (6.4 million in number) while the rate of quit jobs changed a little at 2.5% (decreased by 3.9 million in number). The rate of layoffs and discharges was changed a little at 1.1% (increased to 1.7 million in number). Federal Reserve considers these numbers/ data also before making its policy decisions.
Conclusion – Our Perspective
Any policy measure has a certain time lag to see its results or response from the economy. It is to be seen how and when the economy will respond (or slow down) due to the rapid increase in interest rates by the Federal Reserve. Federal Reserve is in a very tight spot to know about the impact on the economy of the previous tightening before it goes for further tightening (increasing interest rates).
Many investors have stopped their expectations that Federal Reserve will reduce its rates anytime sooner. After Federal Reserve Chair Mr. Powell’s statement, investors expect that interest rates may rise to between 5.5% to 5.75%. Some experts/ economists expect that the interest rate may touch 6% by this year’s end. Federal Reserve should pause a rate hike to know the impact of the previous tightening. However, this also depends on other economic factors (mainly data). Whatsoever it is for sure that further hikes are inevitable.
FAQs
What is the Fed’s policy rate and how does it affect other interest rates?
The Fed’s policy rate is the interest rate that banks charge each other for overnight loans. It is also known as the federal funds rate. The Fed sets a target range for this rate & uses various tools to keep it within that range. The Fed’s policy rate influences other interest rates such as the prime rate, mortgage rates, credit card rates, etc. by affecting the supply & demand of money in the economy.
Why is inflation a concern for the Fed and how does it measure it?
Inflation is a overall increase in the prices of goods & services over time. It reduces the purchasing power of money & erodes the value of savings. The Fed has a dual mandate of promoting price stability & maximum employment. Therefore, it tries to keep inflation at a moderate level that is consistent with these goals. The Fed measures inflation using various indicators such as the Consumer Price Index (CPI), & the Personal Consumption Expenditures (PCE) index, etc.
What is neutral interest rate and why does it matter?
Neutral interest rate is the level of interest rate that neither stimulates nor restrains economic activity. It is also known as natural or equilibrium interest rate. It varies over time depending on various factors such as productivity growth, demographics, & preferences, among others. It matters because it helps to assess whether monetary policy is too tight or too loose for the economy.
How do higher interest rates affect economic growth?
Higher interest rates have both positive & negative effects on economic growth. On one hand, they encourage saving & discourage borrowing, which reduces consumer spending & business investment. They also make US exports more expensive & imports cheaper, which reduces net exports. On the other hand, they attract foreign capital inflows, which strengthens US dollar & increases financial stability. They also reduce inflationary pressures, which enhances consumer confidence & spending power.