The dilemma of the Fed and interest rates

In United States, consumer inflation rises 7.9% over the past year, the steepest increase since 1982 driven by rising costs for gasoline, food and housing. A fact that has triggered alarms in the Federal Reserve.

Even before the war further accelerated price increases, robust consumer spending, solid wage increases and persistent supply shortages they had pushed US inflation to its highest level in four decades.

For most Americans, inflation is well above wage increases that many have received in the last year, making it difficult for them to cover necessities such as food, gasoline and rent.

At the same time, the US labor market added 431,000 jobs in March, while the Unemployment hit a pandemic-era low of 3.6%.

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In this environment, the Federal Reserve should sharply raise interest rates, which today are at 0.5% after the increase last March, the first increase since 2018. However, the monetary authority is caught in a real dilemma.

The dilemma of the Fed that prevents it from raising rates hastily

If we look back, until the end of 2021, the Fed believed that inflation was transitory.

The Fed’s miscalculation caused it to delay raising interest rates last year. In fact, the Federal Reserve was still buying billions of dollars in bonds as late as last month. But the central bank put a brake on this monetary policy in January when it announced plans to stop buying, reduce its balance sheet and start raising rates.

By now we know that Fed Chairman Jerome H. Powell has justified a steady series of seven interest rate hikes this year that may not only reduce skyrocketing inflation, but also help reset the labor market by cool labor demand which is highly stressed.

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Higher interest rates are the Federal Reserve’s benchmark mechanism for combating inflation, since make it more expensive to borrow or invest, and can hold back spending by both households and businesses. If companies decide they don’t need as many employees, the current high demand for workers could also decline.

Failure to raise interest rates aggressively now risks allowing both inflation expectations to take hold and add more foam to already overvalued stock markets.

However, there is another side of the coin. If interest rates were to be raised aggressively now, it could put the inflation genie back in the bottle, but at the price of bursting the current asset price bubble in tech-led equity and credit markets that have been buoyed by 0% interest rate policies.

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In this case, it is necessary to assess what is the worst evil. The right thing to do for the Fed at this point would be to own up to its past policy mistakes and move aggressively to rein in inflation.

The most extreme case was seen in Paul Volcker, president of the Fed who engineered a severe recession in the early 1980s that ended the double-digit inflation of that time, but at the cost of dispelling the unemployment that hit President Reagan’s popularity. For now, the goal is a soft landing. The Fed is looking to gradually move towards higher interest rates, but without emulating Volcker.


Source: El Blog Salmón by www.elblogsalmon.com.

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