US Federal Reserve Raises Interest Rates: How Is It Linked to Inflation?

The spike is the highest since 1994 as the Biden government struggles to contain high, persistent inflation.

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The Federal Reserve of the United States took a drastic decision on Wednesday, 15 June, and raised interest rates by three-quarters of a percentage point.

The spike is the highest since 1994 and is a consequence of persistent inflation in the country that hit 8.6 percent last month.

"We are highly attentive to the risks high inflation poses to both sides of our mandate, and we are strongly committed to returning inflation to our 2 percent objective," Federal Reserve Chair Jerome Powell said at a press conference said on Wednesday.

"Coming out of our last meeting in May, there was a broad sense on the Committee that a 1/2 percentage point increase in the target range should be considered at this meeting if economic and financial conditions evolved in line with expectations... Since then, inflation has again surprised to the upside, some indicators of inflation expectations have risen."

Jerome Powell, Chairperson of Federal Reserve

The Federal Reserve also predicted on Wednesday that the economy will grow at 1.7 percent this year. The forecast in March was 2.8 percent. Unemployment is expected to be at around 3.7 percent by the end of 2022.

Let's understand what this really means. What exactly are interest rates, and how does raising them curb inflation?

Interest Rates

Basically, an interest rate, determined by the central bank of a country, tells us what the cost of borrowing is.

When people, or a company, take a loan (like from banks or on credit cards or mortgages), we pay back the bank more money (the interest) than we borrowed, as remuneration for the bank's services.

The interest rate is the amount we are charged for that loan and is depicted as a percentage of the total amount of money (or capital) borrowed.

The higher the percentage, the more money we pay back to the bank (on top of the loan) as remuneration.

It is important to note that the federal interest rate is an indirect burden on the borrowers.

The burden of the interest imposed by the central bank is on the subordinate banks, which in turn charge borrowers.

Additionally, the central bank is required to keep reserved funds so that it can meet liabilities if there are sudden withdrawals by other banks.

The reserves are also used to increase (or decrease) the money that is roaming around in the economy in order to change interest rates according to the country's needs.

The Link to Inflation

Why are higher rates being used as a tactic to deal with inflation?

The higher the interest rate, the more expensive is the cost of borrowing money.

If the cost of borrowing is high, then what reduces? Spending. And if spending reduces, what reduces alongside? Demand.

If demand drops, then the price of everyday goods drops as well. Additionally, increasing the cost of borrowing deters business from expanding via loans or investments, again reducing demand and bringing prices down.

The Risks of This Strategy

Economists are concerned that if the interest rates are upped too quickly and the demand drops drastically, then the repercussion will be felt by the economy.

If businesses don't expand, or if they stop investing, then they could either stop hiring or fire their workers, leading to higher unemployment.

People wanting to buy homes will also be affected.

"Housing is getting less affordable for everyone at every level," Daryl Fairweather, chief economist at Redfin, told NPR.

Additionally, there is a great risk of a recession, which analysts are warning about due to the inevitable plummet in consumer spending.

"The Federal Reserve is going to hike interest rates until policymakers break inflation, but the risk is that they also break the economy," wrote Ryan Sweet of Moody's Analytics, reported by Bloomberg.

Thomas Garretson, a senior portfolio strategist at RBC Wealth Management, told the Associated Press that the risks of a recession are rising, and preventing it is "going to be a tightrope walk."

"It's not going to be easy," he added.

Chairman Powell did say that the Federal Reserve will try to avoid that. "We're not trying to induce a recession. Let's be clear about that," he said.

Is It a Global Phenomenon?

At least 45 countries have spiked their interest rates in the last six months in order to push borrowing costs higher and contain inflation, the New York Times reported.

Data from FactSet, an American financial data company, shows that some of the larger economies in this category include China, Britain, India, Japan, and Canada.

Russia is an exception with respect to interest rates because of its fluctuating policies.

The central bank raised interest rates above 20 percent right after the Russian military invaded in Ukraine on 24 February.

In the weeks following the spike, however, Moscow slashed its interest rate four times so that they were back to basically what they were before the war began.

(With inputs from the New York Times, the Washington Post, NPR, and CNBC.)