The US Central Bank boss, Jerome Powell, has indicated that he intends to go ahead with the plan to raise the interest rate in an attempt to cool down the rapid inflation the country has been experiencing. This indication of what is likely to happen is known as ‘Forward Guidance’, a tool which the central bank uses to inform financial markets and economic agents as to what the likely future course of monetary policy will take after they make adjustments to it, which thus acts as an indicator for any markets and firms to make any necessary adaptations so that they are better prepared, in this case, to the increase in the interest rate.
This suggestion ensures that confidence is secure in the US financial system; Mr Powell said that he is in favour of a 0.25% increase in the interest rate, with the aim to tackle the surging cost of living. This decision is similar to that of other major economies such as the UK and the Eurozone, with the Bank of England having also recently raised their interest rates, since all of these major economies have been experiencing the highest inflation rates they have seen in decades.
The US rate of inflation reached 7.5% in January, an increase from the 7% rate in December, as measured by the CPI (Consumer Price Index), causing prices to rise at the fastest rate in 40 years. Analysts predict a rate hike in March; the first since 2018. It is predicted to occur as costs for food, fuel and cars have risen sharply in recent months, and subsequently a fall in the purchasing power of money for consumers, in other words leaving families' budgets strained.
Mr Powell admitted that he was open to further interest rate increases further down the line if inflation remains "persistently high", in order to promote disinflation, which is a decrease in the rate of inflation. The idea of raising interest rates is to keep current and predicted price rises under control. However raising interest rates comes at a cost to consumers and producers, since borrowing is more expensive.
For example, for households, that could mean higher mortgage costs, although, for the vast majority of homeowners, the impact is not immediate, and some will escape it entirely, depending on their mortgage. In general, a greater proportion of households' income will have to be used to pay for their more expensive mortgage, which in turn decreases the disposable income of households and increases the cost of living.
Producers will also feel an effect from the raised interest rates; borrowing will be more expensive and so will discourage firms to invest, reducing their abilities to grow and make a profit.
Whilst these could be seen as negative effects toward social welfare, they could be effective in reducing aggregate demand, which will subsequently lead to a decrease in the upwards pressure in prices, and will slowly begin to decrease the inflation rate back to the Federal Reserve’s target of 2%. However, the efforts of this rate rise may be futile as a small rise of 0.25% is unlikely to have a significant enough impact in which the inflation rate would greatly decrease.
The price of Brent crude oil rose above $119 a barrel to the highest since May 2012, while gas prices have also risen after Russia threatened the West that it will break off its gas supply. Both of these factor inputs are essential for all business logistic operations to operate and a rise in their costs will certainly lead to a fall in aggregate supply. Furthermore, international shipping routes are still being disrupted by some lockdowns in Chinese ports, which will consequently lead to a fall in output, and thus aggregate supply too. With the effects of Covid still in force and the conflict in Ukraine threatening the ability of the USA to fuel its economy, the aggregate supply decreasing in the economy will almost certainly lead to an increase in cost-push inflation.
And so whilst the US may see contractionary monetary policy, through raising interest rates, as the solution to their persistent surges in inflation, with the global supply chain affecting the USA, it is difficult to believe that a small change of an interest rate will be able to negate the effects of the cost-push inflation.
Written by Matteo Malefora