The Peculiar Case of the US Interest Hike

On July 27, 2022, the Federal Reserve (Central Bank of the USA) increased the interest rates by 75 points, its second consecutive 0.75% hike (the first one happening in June 2022) in interest rates in the USA. This article will explore- what is the motive behind taking this action and what will be its probable effects on the US Economy. 

The rationale behind increasing the interest rates was to offset the rising inflation in the USA. In the USA, the food, housing and fuel costs have been rising since 2021 and the annual inflation rate has increased from 2.6% in May 2021 to 9.1% in June 2022. But, what has led to such a meteoric rise in prices in the first place? Firstly, people have been buying cars, houses and airline tickets, which they hadn’t bought in 2020 due to the cash crunch caused by the pandemic; secondly, low-interest rates and relief cheques given by the government to households have led to an increase in the demand for fuel and food. 

Now the most important question is, will an increase in interest rate help ease the rising inflation? 

Well, theoretically, it should. When the central bank of a country increases the interest rate, the loan-borrowing power of the consumers and businesses decreases because they are less willing to borrow loans at an increased interest rate. This inability in obtaining loan funds makes them spend less; therefore, decreasing the demand for goods and services. This leads to a decrease in the price of goods and services; thus, mitigating inflation. So, this should be good news for the US economy, right? Yes and no. 

If the Federal Reserve bankers overdo the increase in interest rate, it could tip the entire US economy into a recession (a situation where there is an increase in the supply of goods and services but not enough demand). The Chair of the Federal Reserve, Jerome Powell has said that there will be a point when the Fed starts to slow hikes to assess their impact and avoid a recession. However, as of now, the #1 aim of the American central bankers is bringing down inflation even if it slows down the economy a little bit. 

‍Is the USA In Recession: Quarter-On-Quarter decline in the U.S. GDP

The commerce department of the USA announced on 28 July 2022 that gross domestic product (GDP) decreased at an annualized rate of 0.9% in the second quarter after falling at an annualized rate of 1.6% in the first quarter. It is a widely accepted rule of thumb that that two consecutive quarterly negative growths in GDP account for a recession. 

However, many economists and central bankers believe that this rule of thumb is not applicable to the USA this time because of the strong labour market, which is an important economic indicator. There are roughly 2 jobs open for every unemployed person in America. However, it is imperative that Powell assesses the impact of the interest rates to avoid a recession.

To summarise, the Federal Reserve introduced a hike in the interest rate to combat the rising inflation caused by the economic rebound of the pandemic. If the Fed doesn’t evaluate the impact of this hike and makes tweaks accordingly, the US economy can slide into a recession.