The US Federal Reserve continues the series of interest rate hikes in the fight against inflation. As expected by many investors, it raised interest rates by a quarter of a percentage point to the new range of 5.0 to 5.25 percent on Wednesday. At the beginning of 2022 it was still close to zero. This is now the tenth increase in a row.
The new value is the highest since 2007, i.e. before the start of the global financial crisis. The most recent banking collapse in the US – the collapse of the First Republic Bank – has not stopped the Fed from raising interest rates slightly. Now, however, a break could follow. The base rate is the interest rate at which commercial banks can borrow money from central banks.
In the past year, the Fed had raised interest rates by an impressive 0.75 percentage points several times. The central bank had thus set a pace that it had not seen in decades. She initiated this turnaround in interest rates a good year ago. At that time, the key interest rate was almost zero. Recently, however, the Fed has opted for smaller rate hikes. The US central bankers expect the key interest rate to average 5.1 percent at the end of the year. This value has been reached with the current increase.
When making its decision, the Fed had to weigh up: which is more important, calming concerns in the banking sector or fighting high consumer prices? Because the Fed’s aggressive rate hikes have also intensified some of the turbulence in the banking sector. The collapsed banks had not adequately protected themselves against rising interest rates. Higher interest rates reduced the market value of banks’ securities holdings.
With the First Republic Bank, another struggling US money house has just collapsed. A few days ago it was announced that the industry leader JP Morgan Chase took over the troubled bank in a state-coordinated bailout. After the collapse of Silicon Valley Bank and Signature Bank in March, it initially seemed as if the turbulence was over.
Consumer prices are still too high
The Fed must now manage a balancing act in its monetary policy, because further significant interest rate hikes could unsettle the market. At the same time, consumer prices in the US are still too high. Keeping inflation moderate is the classic task of central banks. If interest rates rise, private individuals and businesses have to spend more money on loans or borrow less money. Growth is slowing, companies cannot simply pass on higher prices and ideally the inflation rate is falling. At the same time, there is a risk that the economy will stall.
The high level of inflation in the USA had recently weakened more than expected. In March, consumer prices rose by five percent compared to the same month last year. It was the lowest increase since May 2021. But that reading is still a long way off the Fed’s target inflation rate of 2% on average. At the same time, the labor market remains robust. What actually sounds good, however, can drive up consumer prices even further. After all, a strong labor market often means that wages will rise and so will inflation.
The recent turmoil in the banking sector could have a similar effect as interest rate hikes and dampen demand due to restrained lending. Fed Chair Jerome Powell also relied on this recently. There is currently unrest on the markets, but also because of the dispute over the debt ceiling. US Treasury Secretary Janet Yellen warned that the world’s largest economy could default as early as June 1 if the debt ceiling is not raised. This is also weighing on the US economy – and could depress growth.