The Federal Reserve announced the rate hike on March 16. This measure is the first in a series of increases planned by the Fed to fight inflation.
In theory, the Fed’s plan should work, said Russell Lay, who teaches economics at College of The Albemarle.
“The question is whether one increase is enough to slow inflation and how many rate increases will we need to achieve that goal.”
Typically, the Federal Reserve targets 2% as the country’s inflation rate, which has climbed nearly 6% since the start of last year.
“It’s worrying,” said Kingsley Nwala, a business and economics professor at Elizabeth City State University.
According to Nwala, the national inflation rate for January was 7.45% and that for February rose to 7.9%. March figures will be available in April.
Officially known as the federal funds rate, the Federal Reserve rate is the interest rate that banks pay to borrow from and lend to each other.
The March 16 increase took the rate nearly 0 percentage points from pre-pandemic to 0.25%, fixing the rate between 0.25% and 0.5%. The central bank is also planning six more rate hikes to bring the headline rate to 1.9% by the end of this year, with three more hikes likely in 2023, Nwala said.
Inflation occurs when the purchasing power of consumers is weakened by the rising costs of almost all goods and services. Essentially, the US dollar today is not worth as much as it was a year ago.
“Inflation erodes your purchasing power,” Nwala said.
One way to deal with rising inflation is to slow consumer spending by raising the Fed’s interest rate, he said. The purpose of the increase in the federal funds rate is to increase the cost of consumer credit, Lay said.
“Inflation happens when too many dollars chase too few goods,” he said. “Banks routinely borrow from each other overnight to meet regulatory liquidity requirements. Since the pandemic, this rate has been zero.
“So any increase in the overnight rate for banks should cause loan interest rates to rise and slow the economy,” Lay continued. “In addition, other indices used to price interest rates on loans, such as the prime rate, crowd out the federal funds rate, so lending rates based on those indices will also rise.”
That means it could be more expensive for residents to borrow money to buy new cars or fund a 30-year mortgage.
Nwala said homeowners who have variable-rate mortgages, as opposed to fixed-rate mortgages, will be hit harder by the Fed’s rate hike.
Lay said residents may not feel the effects of a quarter percent increase. Indeed, housing prices and the costs of household items are rising faster than the cost of credit, he said.
But on larger projects, even small rate increases can translate into big bucks,” Lay said. “If rates increase by 1% or more this year in total, monthly payments could increase enough to prevent some people from qualifying. for a mortgage or car loan, or decide on their own that the payment is now too high.
“Small business owners will also face the same problems if rate increases continue alongside rising inflation for the goods and services they turn into products.”
Nwala explained that two fundamentals of the economy – supply and demand – coupled with shortages in the global supply chain, are partly to blame for inflation.
At the start of the pandemic, millions of workers lost their jobs, which equates to fewer people spending money, according to Nwala. This led to a drop in consumer demand for goods, while the supply was plentiful.
The national unemployment rate in February was 3.8%, a figure that Nwala says is equivalent to almost a fully employed workforce. This is a significant rebound from the millions of jobs lost two years ago.
Along with an unprecedented unemployment rate, consumer spending and demand are rising.
“Now we are at 3.8% unemployment,” Nwala said.
The low unemployment rate also means labor now has the edge over companies looking for new workers, according to Nwala.
“Finding someone to work for you is very competitive,” he said. “Companies are shelling out money to attract workers.”
Nwala also noted that throughout the pandemic, the federal government has injected millions of dollars into the economy in the form of stimulus checks, money to help employers keep workers on their payrolls, subsidies and other means to keep the economy afloat.
Another factor in the Federal Reserve’s decision to raise the policy rate is the war in Ukraine, according to Nwala. “The Russian invasion does not improve the situation,” he said.
The Federal Reserve’s announcement on March 16 takes into account the war in Ukraine.
“Russia’s invasion of Ukraine is causing enormous human and economic hardship,” a press release said. “The implications for the U.S. economy are highly uncertain, but in the near term, the invasion and related events are likely to create additional upward pressure on inflation and weigh on economic activity.”
Lay said inflation was a problem in the United States long before Russia invaded Ukraine. He warned, however, that the war would test existing shortages in the supply chain of many commodities, including oil and wheat. Higher costs for businesses will mean higher prices for consumers, he said.
“That’s why the Fed said future increases could be higher than the 0.25% measures it planned to take this year,” Lay said. “Thus, war will make an already struggling global economy even more unpredictable and likely inflation-prone.”