What is happening

The Federal Reserve is trying to slow inflation by raising interest rates without causing a slowdown, but experts say a “soft landing” seems less likely. The Fed is expected to push rates higher this week.

why is it important

With the Fed’s projections to continue raising rates, there will be consequences – most likely a slight uptick in unemployment.

What this means for you

Soaring consumer prices, falling inventories, rising borrowing costs and the threat of layoffs could prove especially devastating for low- and middle-income Americans.

Experts predict that the Federal Reserve will raise interest rates an additional 0.75 basis points this week. The Fed has already hiked rates three times this year in an attempt to stem soaring inflation. But despite these interest rate hikes, inflation has not yet slowed. In June, inflation rose 1.3%, marking another 40-year high and placing the headline inflation rate at 9.1% over the past 12 months.

Raising interest rates is the main action the Fed can take to counter high inflation. When it costs more to borrow – as it does credit card, mortgages and other loans — consumers have less purchasing power and will buy fewer items, decreasing the “demand” side of the supply-demand equation, theoretically contributing to lower prices. But that hasn’t happened yet, and experts fear that the rising cost of borrowing could contract the economy too much, send us into a recession: an economy in decline rather than growth.

Fed Chairman Jerome Powell has warned that a “soft landing” – achieving 2% inflation with a strong labor market – will not be easy. In an interview with Marketplace, Powell said it would be “quite difficult to accomplish this right now, for a number of reasons. The first is just that unemployment is very, very low, the job market extremely tight, and the very high inflation.”

What is causing record high inflation and what will be its impact on the economy? And what is the next step from the Fed? Here’s everything you need to know.

What’s going on with inflation right now?

In June, inflation soared to 9.1% from a year earlier, reaching its highest level since November 1981, according to the Bureau of Labor Statistics. Gasoline prices rose 11.2% in June, bringing energy’s rise to 41.6% over the past 12 months. Food prices also rose 1% last month, bringing the 12-month increase to 10.4% overall.

During times of high inflation, your dollar has less purchasing power, which makes everything you buy more expensive, even though you probably don’t get paid more. In fact, more and more Americans are living paycheck to paycheck and wages are not keeping up with inflation rates.

Why is inflation so high?

In short, much of this can be attributed to the pandemic. In March 2020, the outbreak of COVID-19 caused the US economy to shut down. Millions of employees were laid off, many businesses had to shut down, and the global supply chain was abruptly put on hold. This has halted the flow of goods produced and manufactured overseas and shipped to the United States for at least two weeks, and in many cases, for months, according to Pete Earle, an economist at the American Institute for EconomicResearch.

But the reduction in supply has been accompanied by increased demand as Americans have started to buy durable goods to replace the services they used before the pandemic, said Josh Bivens, director of research at the Economic Policy Institute. “The pandemic has created distortions on both the demand and supply side of the U.S. economy,” Bivens said.

Although the immediate impacts of COVID-19 on the U.S. economy are easing, labor disruptions and supply and demand imbalances persist, including shortages of microchips, steel, equipment, and other goods, leading to continued slowdowns in manufacturing and construction. According to the World Bank, unforeseen shocks to the global economy have made matters worse, especially subsequent COVID variants, lockdowns in China (which impact the availability of goods in the United States), and war in Ukraine ( which affects gas prices).

Powell confirmed the World Bank’s findings at the June Fed meeting, calling these external factors difficult because they are beyond the central bank’s control.

Some lawmakers have also accused companies of taking advantage of inflation to raise prices more than necessary, a form of price gouging.

What is the role of the Federal Reserve in inflation?

As inflation hits record highs, the Fed is under heavy pressure from policymakers and consumers to get the situation under control. One of the main objectives of the Fed is to promote price stability and to keep inflation at a rate of 2%.

By raising interest rates, the Fed aims to slow down the economy by making borrowing more expensive. In turn, consumers, investors, and businesses stop to make investments and purchases on credit, leading to a reduction in economic demand, theoretically lower prices, and a balance between supply and demand. .

The Fed raised the federal funds rate by a quarter of a percentage point in March, followed by half a percentage point in May and three-quarters of a percentage point in mid-June. The federal funds rate is the interest rate that banks charge each other to borrow and lend. And there’s a ripple effect: when it costs banks more to borrow from each other, they make up for it by raising the rates on their consumer loan products. This is how the Fed effectively raises interest rates in the US economy.

The fed funds rate is now in a range of 1.5% to 1.75%. But the Fed thinks that needs to rise significantly to see progress on inflation, likely in the 3.5% to 4% range, according to Powell.

However, rising interest rates can only reduce inflationary pressures to a certain extent, especially when the current factors are largely on the supply side – and are global. A growing number of economists say that the situation is more complicated to control and that the Fed’s monetary policy alone is not enough.

Could rising interest rates trigger a recession?

We cannot yet determine how these policy measures will have a general impact on prices and wages. But with three more rate hikes scheduled for this year, there are concerns that the Fed could overreact by raising rates too aggressively, which could trigger a more painful economic downturn or create a recession.

The National Bureau of Economic Research, which has not yet officially determined whether the United States is in a recession, defines a recession as “a significant decline in economic activity that spreads throughout the economy and lasts more than a few months”. This means a decline in gross domestic product, or GDP, alongside falling production and retail sales, as well as falling incomes and falling employment.

Rising rates too quickly could reduce consumer demand too much and unduly stifle economic growth, leading businesses to lay off workers or stop hiring. This would drive up unemployment, which would cause another problem for the Fed, as it is also responsible for maintaining maximum employment.

Generally speaking, inflation and unemployment have an inverse relationship. When more people work, they can afford to spend, leading to increased demand and high prices. However, when inflation is low, unemployment tends to be higher. But with prices that remain exorbitant, many investors are increasingly worried about an upcoming period of stagflation — the toxic combination of slow economic growth with high unemployment and inflation.

Here’s what higher interest rates mean to you

Over the past two years, interest rates had hit historic lows, in part because the Fed cut rates in 2020 to keep the US economy afloat in the face of lockdowns. The Fed has kept interest rates near zero, a decision taken only once before, during the 2008 financial crisis.

For the average consumer, the increase in interest rates means that buying a car or a house will cost more, since you will pay more interest. Higher rates could make it more expensive to refinance your mortgage or student loans. Additionally, Fed hikes will drive up credit card interest rates, which means your debt on outstanding balances will increase.

Securities and crypto markets could also be negatively affected by Fed decisions to raise rates. When interest rates rise, money is more expensive to borrow, reducing liquidity in the crypto and equity markets. Investor psychology can also cause markets to fall, as cautious investors may shift their money from stocks or crypto to more conservative investments, such as government bonds.

On the other hand, rising interest rates could mean a slightly better return on your savings accounts. Interest rates on savings deposits are directly affected by the federal funds rate. Several banks have already increased annual percentage yields, or APYs, on their savings accounts and certificates of deposit following the Fed’s rate hikes.

We will keep you updated on the changing economic situation as it evolves.

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