PremiumThe Federal Reserve of the United States, the American central bank, has decided to start raising interest rates. On Wednesday, it raised its key short-term interest rate, the federal funds rate, by 25 basis points. One basis point is one-hundredth of a percentage.
Why raise rates?
Inflation or the rate of price rise, in the United States, has been at a four-decade high. The retail inflation in February was at 7.9%. The last time inflation was anywhere near this level was in January 1982, when it was at 8.3%.
A lot of this has been due to supply disruptions, first due to the spread of the pandemic and then later due to Russia attacking Ukraine and pushing up prices of oil, natural gas and other commodities.
As the Federal Reserve said in a statement: “Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures. The invasion of Ukraine by Russia is causing tremendous human and economic hardship."
Of course, there is no way a central bank can control inflation due to issues on the supply side. So, why raise rates then? People also react to inflation. They look at recent high inflation and assume that it is likely to continue. Median one-year inflation expectations in the United States in February were at 6%. This is the highest they have been from June 2013, the starting month from which data is available. When expectations of future inflation are so high, people start factoring this in their wage demands, leading to higher wage inflation, and inflation becoming systemic.
This is something that Federal Reserve does not want to happen and hence, over the years it has tried to set interest rates with the aim of maintaining inflation at 2%. And in order to do this, it needs to raise interest rates and rein in consumption or the demand for goods and services, and in the process hope to bring down inflation.
What more is expected?
With inflation at 7.9%, raising the interest rate by 25 basis points isn’t going to do much to control it. Nonetheless, the Federal Reserve also needs to ensure that it doesn’t give the financial system and the economy a shock by being too aggressive in raising rates. Data released by the Federal Reserve suggests that the median federal funds rate is expected to be at 1.9% in December 2022. Given that there are six meetings of the Fed remaining this year, it means that interest rate hikes are likely in each of these six meetings. With these hikes, the Federal Reserve hopes to rein in inflation at 2.6% by the end of the year. This looks a tad optimistic given how high inflation currently is.
Also, the Federal Reserve expects inflation to touch its comfort zone of around 2% only in 2024. The median projection of inflation for 2024 is 2.1%.
Why are the stock markets going up?
Stock prices all over the world have gone up after the Federal Reserve’s decision to raise rates. At the time of writing this, the BSE Sensex, India’s premier stock market index, was up by more than 1,000 points, or around 1.8% from close on Wednesday. This is happening primarily because the Federal Reserve hasn’t sprung any surprises. The market was expecting it to raise interest rates by 25 basis points and which is what it did. Inflation isn’t good for stocks and the move to control it is being welcomed.
Nonetheless, as the Fed keeps raising rates, stock markets will come under pressure. With interest rates in the United States going up, money is likely to move out from other parts of the world and find its way to America.
The era of easy money
There is another point that needs to be made here. Since September 2008, when Lehman Brothers, the fourth-largest investment bank on Wall Street, went bust, the central banks of the rich world, led by the Federal Reserve have printed a lot of money and pumped it into the financial system to keep interest rates low, in order to encourage people and companies to borrow and spend.
In fact, this money printing increased dramatically from early 2020 onwards once the covid pandemic started spreading. An estimate made by The Economist suggests that the rich-world central banks have printed close to $12 trillion in the last two years. This money needs to be gradually sucked out of the system.
The Federal Reserve said that the decision to do so would be made at a coming meeting. As and when this happens and to the condition that it continues, the era of easy money the world has got so used to, will start coming to an end. This is when stock prices will take a genuine beating. Of course, they have already come down a little from their all-time high levels achieved last year.
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