Fed Announces the Biggest Interest Rate Hike in 28 Years: What’s Next for Inflation?

What’s happening

The Federal Reserve announced its latest rate hike today, the largest increase in almost three decades, to help calm red-hot inflation levels.

Why it matters

After two rate hikes failed to tame soaring prices, May’s 8.6% inflation rate has financial experts worried that a recession might be on the horizon.

What it means for you

A hike in rates makes it more expensive for you to borrow money, and usually leads to higher credit card interest and increased mortgage rates.

On Wednesday, the Federal Reserve announced the largest interest rate increase since 1994 in an attempt to tame rampant inflation

The central bank ratcheted up interest rates by 0.75 percentage points, bringing the federal funds rate into a range of 1.5% to 1.75%. This increase is more aggressive than the Fed’s 0.25 percentage point increase in April and 0.50 percentage point increase in May.

Though inflation showed signs of leveling off in April, the Consumer Price Index reading for May showed that inflation isn’t slowing down. In May, inflation climbed by 1%, placing the rate at a 40-year high of 8.6% for the past 12 months. 

The CPI numbers came just days ahead of the Fed’s June meeting, propelling the central bank to take swift and bold action to quell rising prices. And this likely won’t be the final rate hike, as economists estimate the Fed will raise the federal funds rate several times by year’s end.

What does this mean for you? Historically, raising rates is a key step the Fed takes to combat rampant inflation, but it also means rate increases for credit cards, mortgages and other loans. In other words, the cost of borrowing goes up, making it more expensive to finance a home, car and other essential purchases.

What’s causing this record-high inflation level? And what does the Fed plan to do next? Here’s everything you need to know.

How high is inflation today?

Inflation surged in May, increasing 8.6% over the previous year and reaching its highest level since December 1981, according to the Bureau of Labor Statistics. Excluding energy and food prices, which tend to be volatile, core inflation climbed by 0.6% last month. Gas prices rose 4.1% in May, bringing the increase in gas prices to 48.7% over the past 12 months. Food prices also increased, by 1.2% in May, bringing that 12-month increase to 10.1%, overall. 

During periods of high inflation, your dollar has less purchasing power, making everything you buy more expensive even though you’re likely not getting paid more. In fact, more Americans are living paycheck to paycheck, and wages aren’t keeping up with inflation rates. 

Inflation itself isn’t inherently a good or bad thing. Moderate and steady inflation is actually important for a healthy economy: It promotes spending, since rising prices encourage consumers to buy now, rather than later, keeping demand up. Inflation can become a problem when it rises over 2% (as measured by the Fed) and when it rises rapidly. That messes with healthy consumer spending and, in extreme cases, can derail price stability.

Though the immediate impacts of COVID-19 on the US economy are easing, supply and demand imbalances persist and are one of the main contributors to higher prices. Russia’s war on Ukraine, which threatens political and economic stability worldwide, is a key driver of skyrocketing gas prices. 

How did inflation get so bad?

Essentially, we’re here because of the pandemic. However, unanticipated shocks to the US economy have made things worse.

In March 2020, the onset of COVID-19 caused the US economy to shut down. Millions of employees were laid off, many businesses had to close their doors and the global supply chain was abruptly put on pause. This caused the flow of goods shipped into the US to cease for at least two weeks, and in many cases, for months, according to Pete Earle, an economist at the American Institute for Economic Research.

But the reduction in supply was met with increased demand as Americans started purchasing durable goods to replace the services they used prior to the pandemic, said Josh Bivens, director of research at the Economic Policy Institute.

“The pandemic put distortions on both the demand and supply side of the US economy,” Bivens said. “On the demand side, it channeled tons of spending into the narrow channel of durable goods. And then, of course, that’s the sector that needs a healthy supply chain in order to deliver goods without inflationary pressures. We haven’t had a healthy supply chain overwhelmingly because of COVID.”

This combination of supply chain kinks and an increase in demand induced inflation, which has persisted since the 2021 reopening of the economy. 

All this has had the effect of increasing consumer prices, something made worse by subsequent COVID variants, lockdowns in China, and Russia’s invasion of Ukraine, according to the World Bank.

What is the Federal reserve doing about inflation?

With inflation hitting record highs, the Federal Reserve, the government body in charge of keeping inflation in check, has been under a great deal of pressure from policymakers and consumers to get the situation under control. One of the Fed’s primary objectives is to promote price stability and maintain inflation at a rate of 2%. 

To counteract inflation’s rampant growth, the Fed raised the federal funds rate by a quarter of a percentage point in March, followed by a half of a percentage point increase in May and a three quarter of a percentage increase today. When the Fed first raised rates, in March, it projected there could be as many as six rate hikes throughout the year.

The federal funds rate is the interest rate that banks charge each other for borrowing and lending, usually on an overnight basis. By raising this rate, the Fed effectively drives up interest rates in the US economy.  

Raising interest rates helps slow down the economy by making borrowing more expensive. In turn, consumers, investors and businesses pause on making investments, which leads to reduced economic demand and theoretically reels in prices. In short, this helps balance the supply and demand scales, one cause of inflation that was thrown out of whack by the pandemic.

The Fed, which calculates inflation differently than the CPI, estimated that inflation was at 6.3% as of April. The typical Federal Open Market Committee member — the Fed’s policy-making body — projects this number could decrease to 4.3% by the end of the year, following a series of rate hikes. 

What do rising interest rates mean for you?

Raising interest rates will make it more expensive for both businesses and consumers to take on loans. For the average consumer, that means buying a car or a home will get more expensive, since you’ll pay more in interest. 

For the past two years, interest rates have been at historic lows, partially because the Fed slashed interest rates in 2020 to keep the US economy afloat in the face of lockdowns. Since then, the Fed has kept interest rates near zero, a move made only once before, during the financial crisis of 2008. Prior to the Fed’s recent rate hike, interest rates had already started rising in 2022. For example, 30-year fixed mortgage rates, while still historically low, are returning to pre-pandemic levels. 

Increasing rates could make it more difficult to refinance your mortgage or student loans at lower interest rates. Moreover, the Fed hikes will drive up interest rates on credit cards, ratcheting up minimum payments as well.

Securities and crypto markets could also be negatively impacted by the Fed’s decisions to raise rates. When interest rates go up, money is more expensive to borrow, leading to less liquidity in both the crypto and stock markets. Investor psychology can also cause markets to slide, as cautious investors may move their money out of stocks or crypto into more conservative investments.

On the flip side, rising interest rates could mean a slightly better return for your bank account. Interest rates on savings deposits are directly affected by the federal funds rate. Several banks have already increased annual percentage yields, or APYs, on their savings accounts in the wake of the Fed’s rate hikes.

Are we headed into a recession?

Though these recent rate hikes were expected to help bring down inflation, May’s CPI reading shows the situation may be more complicated to get under control.

Moreover, there’s still a concern on the table, as another three rate hikes are expected this year. If the Fed overreacts by raising rates too high, it could spark an economic downturn, or worse, create a recession. 

Raising rates too quickly might reduce consumer demand too much and unduly stifle economic growth, potentially leading businesses to lay off workers or stop hiring. That could drive up unemployment, which would lead to another problem for the Fed, as it’s also tasked with boosting employment. 

But with inflation persisting and threatening to become entrenched in the US economy, Powell acknowledged that the Fed will raise interest rates more aggressively if needed. “The Committee is determined to take the measures necessary to restore price stability,” Powell said in May. “The American economy is very strong and well positioned to handle tighter monetary policy.”

We’ll keep you updated on the evolving economic situation as the Fed addresses its decision to hike rates up by 0.75 percentage points today.

source: cnet.com