Explained | Will the U.S. Federal Reserve resume the rate hike cycle? Premium

The U.S. Federal Reserve paused its rate hike cycle by deciding to hold interest rates after ten rate hikes, this article explains the reasons and what is to expect in the next few months.

The story so far: The U.S. Federal Reserve (Fed) last week paused its rate hike cycle by deciding to hold interest rates after ten rate hikes since March 2022. The central bank kept its target for the benchmark federal funds rate between 5% and 5.25% until its next policy meeting. Many analysts, however, expect the Federal Reserve to resume its rate hikes and some even expect the federal funds rate to hit 6% soon.

Central banks around the world try to steer their economies primarily by targeting interest rates at which lending/borrowing happens in the short-term credit markets. For instance, if a central bank wants to lower short-term interest rates, it can enter the market where banks borrow funds for their short-term needs with fresh funds, bid up the price of these loans and thus lower interest rates. The fresh money injected into the banking system, in turn, would tend to percolate into the economy and cause prices to rise in the wider economy. A central bank can thus use monetary policy to influence prices in the wider economy. And keeping inflation within a certain target range is a major goal of central banks.

Another policy goal that central banks try to meet along with the inflation target is to keep the economy operating at its full capacity wherein all resources are fully employed. Many economists believe that there is a trade-off between inflation and unemployment. According to this framework, if inflation falls too low, this can cause a rise in unemployment and hence unused capacity. So, the agenda of most central banks is to keep inflation up at a certain level at which the economy functions at full capacity. Inflation above a certain level, however, is seen as having no positive effect on economic activity.

U.S. Fed Chairman Jerome Powell said that the central bank is waiting for signs that there has been a decisive slowdown in inflation before it decides on further actions. It should be noted that the Fed began raising interest rates after inflation hit multi-decade highs as the U.S. economy slowed down due to the Covid-19 lockdowns and the U.S. central bank responded by flooding the economy with massive amounts of dollars. While inflation has dropped from a peak of 9.1% in June last year to 4% in May this year, it is still higher than the Fed’s stated target of keeping inflation within 2%. And even though US unemployment has risen slightly to 3.7% in May this year, it has witnessed a steady fall since the highs seen during the pandemic. In other words, the labour market does not seem to be heavily affected by the Fed’s rate hikes since last year. It must also be understood that the effects of monetary policy usually take time to show up in terms of their impact on prices in the wider economy. So, the Fed may be cautious after a series of ten rate hikes about allowing interest rates to rise too much too soon. A rapid withdrawal of monetary support can cause prices to undershoot the Fed’s inflation target, something the U.S. central bank may not want.

The Fed’s rate hike pause is no guarantee that there won’t be any future rate hikes in the short term. Other western central banks have continued to raise rates after a pause, and major central banks such as the European Central Bank and the Bank of England continue to raise interest rates as inflation continues to be a challenge in their economies. It is hard to predict the trajectory of economic indicators such as growth and inflation, or even the response of central banks with any level of certainty since there are multiple complex variables at play at the same time. For example, many economists over the last year or so have been trying to predict a recession in the U.S. without much success. It can only be said that the U.S. Federal Reserve’s actions are likely to be influenced by several factors including inflation, economic growth and political compulsions ahead of the U.S. Presidential elections next year.