What does the latest interest rate hike by US Federal Reserve mean?

15 Dec 2022 , 08:54 AM

US Federal Reserve ,yesterday , raised interest rate by another 50 basis points or 0.5%. The latest interest rate hike is less than .75% hikes that were announced in the past four instances of interest rate hike this year. After this increase, the benchmark federal funds rate in US now stands at between 4.25% – 4.5%.  This is the highest level of federal funds rate in more than one decade. Federal Funds Rate is the rate that banks charge for overnight lending to other banks. 

US Federal Reserve Chairman said that in  the upcoming meeting of Federal Reserve on 1st February, it may go for a lower interest rate hike of 25 basis points or 0.25%. Federal Reserve also said that federal funds rate is expected to be increased to 5% – 5.5% by the end of 2023. This means that it is planning to raise interest rate by another 1% point at least, over the next 12 months.

In spite of four interest rate hikes, besides the most latest one, US Federal Reserve has achieved very little success, if any, in controlling inflation. Consumer price inflation in November slowed down marginally to 7.1% in November, from 7.7% rate in October. This is still significantly higher than Federal Reserve’s target of 2%.

The Central Bank again asserted yesterday that it will maintain its target inflation rate at 2%. If after so many interest rate hikes, inflation has come down so marginally, what is the quantum of interest rate hikes the Federal Reserve will have to make to bring it down to 2%? The answer is clear. US Central Bank is banking on bringing a sharp recession in the US economy. This recession will slow down demand in the economy to such an extent that inflation starts plummeting down on its own. But in this calculation it is ignoring one major factor. The current spike in inflation rate in US is caused by supply chain disruptions caused by two years of Covid lockdowns and disruptions. It has Not been caused by spike in demand. So increasing interest rates may end up bringing a situation of both economic recession and high inflation. 

The latest increase in federal funds rate will increase mortgage loan interest rates and other interest rates in the US economy further. Housing market has already entered into a sharp slowdown because of increase in rates on mortgage loans. More interest sensitive items of consumption and investment are going to see decline in demand in the coming months. A decline in demand in US will further aggravate the global economic slowdown.