The move announced by the Fed after its last policy meeting will raise the short-term benchmark interest rate, which affects many consumer and business loans, from 1.5% to 1.75%.
The central bank is stepping up its efforts to tighten credit and slow growth with inflation reaching a four-decade high of 8.6%, spreading to more sectors of the economy and showing no signs of slowing down. Americans are also beginning to expect high inflation to last longer than before. This sentiment could incorporate an inflationary psychology into the economy that would make it harder for inflation to return to the Fed’s 2% target.
The Fed’s rate hikes are three-quarters higher than the half-point increase previously suggested by President Jerome Powell that was likely to be announced this week. The Fed’s decision to impose interest rates as high as Wednesday was an acknowledgment that it was struggling to contain the pace and persistence of inflation exacerbated by Russia’s war with Ukraine and its impact on energy prices.
Borrowing costs have already risen sharply in much of the US economy in response to the Fed’s move, with the average fixed 30-year mortgage rate hovering above 6%, its highest level since the 2008 financial crisis, since just 3% in the beginning. of the year. The yield on the 2-year government bond, a benchmark for corporate lending, jumped to 3.3%, its highest level since 2007.
Even if a recession can be avoided, economists say it is almost inevitable that the Fed will have to cause some pain – possibly in the form of higher unemployment – as the price of a victory over chronic high inflation.
Inflation has peaked in the months leading up to the midterm elections, hurting public opinion on the economy, weakening President Joe Biden’s approval ratings and increasing the chances of a Democrat losing in November. Biden tried to show that he recognizes the pain of inflation in American households, but he struggled to find political action that could make a real difference. The president stressed his belief that the power to curb inflation rests primarily with the Fed.
However, the Fed’s rate hike is a blunt tool in trying to reduce inflation while sustaining growth. Shortages of oil, gasoline and food are driving inflation. The Fed is not ideal for tackling many of the roots of inflation, which include Russia’s invasion of Ukraine, still clogged global supply chains, labor shortages and growing demand for services from airline tickets to restaurant meals.
Expectations of bigger increases by the Fed have pushed a number of interest rates to the highest points in recent years. The yield on the 2-year government bond, a benchmark for corporate bonds, reached 3.3%, the highest level since 2007. The yield on the 10-year bond, which directly affects mortgage rates, reached 3.4 %, almost half the point from last week and the highest level since 2011.
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Investments around the world, from bonds to bitcoin, have declined in recent months amid fears of high inflation and the prospect that the Fed’s aggressive attempt to control it will cause a recession. Even if the Fed manages to trick inflation into a slump without causing a recession, higher interest rates will put pressure on stock prices. The S&P 500 has already sunk more than 20% this year, meeting the bear market definition.
Other central banks around the world are also moving fast to curb rising inflation, even with their countries at greater risk of recession than the US. The European Central Bank is expected to raise interest rates by a quarter in July, the first 11-year rise. It could announce a bigger increase in September, if record levels of inflation persist. On Wednesday, the ECB pledged to create a market backstop that could protect member states from the financial turmoil of the kind that erupted during a debt crisis more than a decade ago.
The Bank of England has raised interest rates four times since December to a 13-year high, despite forecasts that economic growth will remain unchanged in the second quarter. The BOE will hold an interest rate meeting on Thursday.
The 19 European Union countries that use the euro recorded record inflation of 8.1% last month. The United Kingdom hit a 40-year high of 9% in April. While debt service costs remain subdued for the time being, rising borrowing costs for heavily indebted governments have threatened the eurozone with disintegration at the beginning of the last decade.
Last week, the World Bank warned of the threat of “stagnant inflation” – slow growth accompanied by high inflation – around the world.
A key reason a recession is now possible is that economists increasingly believe that to slow the Fed to 2% inflation, it will need to sharply cut consumer spending, wage gains and economic growth. . Eventually, the unemployment rate will almost certainly have to rise – something the Fed has not yet predicted, but it could in the economic forecasts released on Wednesday.
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