Federal Reserve Announces Largest Interest Rate Hike in Over 20 Years in Effort to Tame Inflation - What Does It Mean?

What’s the story?

• Federal Reserve Chairman Jerome Powell on Wednesday announced the largest hike to U.S. interest rates in over two decades in an effort to tame inflation in the economy, which has surged to a 40-year high. This comes after the U.S. economy contracted in the first quarter of this year, and would technically enter a recession if that trend continues in the second quarter.
• The Federal Reserve will raise its benchmark interest rate, known as the federal funds rate, by half a percentage point (0.50% or 50 basis points) ― which is the largest hike since 2000. That will bring the federal funds rate to a range of 0.75% to 1%. 
• Powell signaled that further hikes of that size are expected to be considered in the months ahead as the Fed tries to mitigate inflation, although larger hikes of 75 basis points at a time “is not something the committee is actively considering.” Markets expect that the rate may reach 2.75% to 3% by the end of the year per data from the CME Group.
• The chairman opened his remarks at a news conference by delivering a message to the American people about economic conditions:

“Inflation is much too high and we understand the hardship it is causing, and we’re moving to expeditiously bring it back down. We have both the tools we need and the resolve it will take to restore price stability on behalf of American families and businesses. The economy and the country have been through a lot over the past two years and have proved resilient. It is essential that we bring inflation down if we are to have a sustained period of strong labor market conditions that benefit all.”

What is inflation and how is it measured?

• Inflation is a measure of the decline of purchasing power for a given currency over time, which in the U.S. means that a dollar effectively buys less than it did in prior periods because prices rise.
• Inflation can be caused by imbalances of supply and demand in the economy. On the demand side, if there is strong consumer demand that suppliers are constrained in meeting through increased production, prices will rise. On the supply side, increases in production costs like raw materials or wages lead to those costs being passed onto consumers through higher prices for goods produced. 
• Fiscal policies can also contribute to inflationary pressures in the economy by increasing discretionary income for businesses and consumers. The government can attempt to stimulate the economy through transfers of cash to consumers and raising their discretionary income, or by increasing spending on things like infrastructure, both of which can cause inflation. It can also cut taxes that result in businesses spending more on things like capital projects, raising employees’ wages, and hiring new employees; or giving consumers more after-tax income leading to elevated demand for goods and services. 
• Additionally, the monetary policy of a central bank like the Federal Reserve can contribute to inflation when it lowers interest rates to expand the money supply and thereby stimulate more spending by businesses and consumers.
• The most common way inflation is measured is through the Consumer Price Index for Urban Consumers (CPI-U), which shows changes in prices paid for a “representative basket of goods and services” by an urban consumer group representing about 93% of the U.S. population.
• CPI-U includes food, energy, commodities like cars and clothes, plus services such as rent and healthcare; and the relative importance of each to the overall basket shifts according to its proportion of all spending in a given month. This overall number is known as “headline” CPI, although economists also track a metric called “core” CPI which excludes food and energy because those categories tend to have more volatility.
• Inflation can also be measured through the Producer Price Index (PPI), which measures prices for inputs and expenses incurred by producers and suppliers of goods. If producer prices rise, it can eventually cause the CPI to rise as those higher prices are passed onto consumers.
• The Federal Reserve aims to keep inflation at about 2% as part of its dual mandate of promoting stable prices and full employment, as a modest amount of inflation is viewed as an optimum policy in terms of encouraging consumer spending without penalizing savings and investment. When inflation starts to get out of control, the Fed raises interest rates to encourage more savings and less consumer spending.

How does the Fed carry out monetary policy?

• There are three major tools that the Fed has at its disposal to conduct monetary policy and attempt to influence interest rates and the value of the dollar: open market operations, changes in the discount rate, and modifying financial institutions’ reserve requirements. Here’s a look at how those tools work:
• Open market operations (OMO) impact the money supply through sales or purchases of U.S. Treasury bonds to influence the interest rate up or down — whichever is more desirable given economic conditions. When the Federal Reserve buys bonds, the money supply grows and interest rates decrease. Conversely, when it sells bonds, the money supply shrinks and interest rates rise.
• The discount rate is the interest rate that Federal Reserve Banks charge depository institutions, such as commercial banks, for short-term loans borrowed directly from the Federal Reserve. This can be raised or lowered to affect interest rates and access to credit. 
• Reserve requirements for depository institutions — which is the ratio of reserves to deposits those institutions are required to maintain in their vaults or on deposit at a Federal Reserve Bank — can be raised or lowered to affect the money supply and influence interest rates. If depository institutions expect to have greater balances than required, they can lend to another bank and charge the federal funds rate, which is the Federal Reserve’s target interest rate. The federal funds rate is typically lower than the discount rate. 
• In general, if the economy is growing rapidly and there are concerns about inflation rising to a level that erodes consumers’ purchasing power, the Federal Reserve might raise interest rates and shrink the money supply. It can also attempt to rein in the availability of credit by raising reserve requirements and the discount rate.
• On the flip side, if the economy is in recession or sluggish, the Federal Reserve will attempt to broaden the money supply and lower interest rates to encourage economic growth. Meanwhile, it can make credit more available to businesses and consumers by easing reserve requirements.

RELATED READING

• What is the Federal Reserve?
• Inflation Surged to a New 40-Year High of 8.5% in March (4/12/22)

— Eric Revell

(Photo Credit: Federalreserve via Flickr / Public Domain)