Yesterday, the Federal Reserve announced a quarter-point increase in its benchmark interest rate, bringing it to the highest level in 22 years. This decision comes as the Fed grapples with how to control inflation and further tighten the US economy. The rate hike was supported unanimously by the Federal Open Market Committee, marking one of the most aggressive monetary tightening campaigns in decades.
This move is significant because interest rate hikes have been relatively rare in recent years and have often been quickly reversed. However, the Federal Reserve’s statement highlights the need to catch up on interest rate increases after wrongly dismissing a surge in inflation as transitory.
While the Fed may try to present this as a bold and aggressive monetary policy, the statement reveals that their previous rate hikes have already had an impact on interest-rate-sensitive sectors like housing and investment. The full effects of their ongoing monetary restraint are yet to be fully realized, especially in regards to inflation.
It is worth noting that controlling inflation is the Federal Reserve’s primary responsibility. However, using core inflation numbers to justify higher interest rates seems desperate, considering that relying on core inflation played a role in their previous misjudgment of inflation as transitory.
Furthermore, the Federal Reserve’s lack of mention of the money supply is striking. Recent data shows a decline in the M1 and M2 money supplies, indicating a tightening of the brakes in both the short and long term. If we interpret these numbers literally, achieving the inflation target would result in a contraction of the US economy by 1.6% annually in 2025.
In addition to reducing the money supply, the Fed is also actively selling off its bond holdings. Last week alone, they sold $20.5 billion worth of bonds. This tightening of policy is occurring alongside discussions of lowering interest rates, an approach that seems contradictory and may not be beneficial for the overall economy.
The Federal Reserve’s understanding of interest rate hikes may be flawed. In the past, rate hikes have had minimal immediate effects. However, this could be changing due to a growing number of US homeowners with long-term fixed-rate mortgages. Only new buyers would be affected by higher mortgage rates, while existing homeowners would only feel the impact when it comes time to renew their mortgages.
Additionally, businesses that locked in low rates during the Fed’s loose monetary policy in 2020 and 2021 are unlikely to be significantly impacted by the rate hikes. However, those who were unable to secure low rates will feel the pinch.
Overall, the Federal Reserve’s approach to interest rate hikes and inflation targeting raises concerns. Relying on core inflation as a signal has proven ineffective, especially considering the recent rise in energy costs. Additionally, the potential economic consequences of rate hikes could be severe, as the elastic effect of interest rate adjustments may hit harder and create economic instability. It may have been wiser to wait for more evidence before implementing further rate hikes. The weakening US dollar also reflects market skepticism towards the Fed’s plans and rhetoric.
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