Why the Fed isn’t done raising interest rates yet

The Fed has raised rates again. Why?

The federal funds rate is the interest rate at which banks lend money held by them in the Federal Reserve system to each other on an overnight basis. By increasing this rate, the Fed hopes to push up interest rates in the economy and in the process discourage consumption and investment. By discouraging consumption, the Fed hopes that less amount of money will chase goods and services. By discouraging investment, the Fed hopes that fewer jobs will be created. This should slow down wage growth. Overall, the move should help to slow down the rate of price rise or inflation.

Were there any expectations of a cut?

The US is facing a mini-banking crisis with three banks having gone bust. Primarily, banks go bust when loans aren’t repaid. But this time, the case is different. Other than lending, banks also invest in bonds, both those issued by the government and those by private firms. Bond prices are inversely related to interest rates. Therefore, as the Fed has raised interest rates bond prices have fallen. And this has created a problem for many banks, especially when they have had to sell bonds to repay deposits. This has led to losses. Hence, the expectation was that the Fed might not raise rates.

So, why did the Federal Reserve still raise the rate?

Inflation is still significantly higher than Fed’s long-term goal of 2%. In January, the personal consumption expenditures price index, the preferred measure for inflation, rose by 5.4%, compared to the targeted 2%. In fact, the Fed expects inflation to come down to around 2% only in 2025. As Fed chairman Jerome Powell said: “inflation pressures continue to run high".

Have we seen the last of the Fed rate hikes?

As Powell put it: “Ongoing rate increases will [not] quell inflation; instead… some additional policy firming may be appropriate." This means that the Fed will increase rates further. If interest rates go up more, bond values will fall more, putting small- and mid-sized banks under further pressure. But this is a risk that the Fed is willing to take on, because as Powell said “high inflation imposes significant hardship as it erodes purchasing power, especially for those least able to meet the higher costs of essentials".

What does it mean for the Indian economy?

Central banks typically tend to mirror the Fed. Given this, it is highly likely that the Reserve Bank of India will increase the repo rate or the interest at which it lends to banks, when it meets next in early April. This means instalments on loans may go up further. Also, with interest rates in the US going up, foreign investors have better investment options available there, implying that the Indian stock market is likely to remain dull. Also, the rupee dollar exchange rate might come under further pressure.