In just six months, it seemed unprecedented for the Federal Reserve to raise interest rates by 75 basis points. However, as of now, the Fed has done so twice in a row.
After its latest monetary policy meeting, the Fed decided to raise its key interest rate by a quarter of a percentage point. The central bank members voted unanimously in favor of the rate hike.
The Fed's decision to raise interest rates clearly signals that it's willing to take the necessary steps to prevent the economy from overheating.
In their statement, the Fed officials noted that the recent indicators of production and spending have indicated a soft patch.
However, they said that the unemployment rate remained low and job gains have been substantial. They also added that inflation is still elevated due to the effects of the pandemic and other factors.
In previous months, the central bank noted that rising energy prices contributed to the inflation rate. However, this month, they also included food costs in their calculations.
Zero interest rate leads to catastrophe
When the pandemic outbreak first hit the U.S., the Fed responded by implementing various emergency measures. One of these was slashing its key interest rate to zero. Doing so made it easy for businesses and households to borrow money. Unfortunately, this policy also led to an overheating economy.
After the economy started to recover, the Fed decided to stop supporting the economy by raising interest rates. This policy aims to slow the growth rate and remove the punch bowl from the financial system.
The Fed's actions will lead to higher interest rates for consumers and businesses. The central bank's target for overnight lending will likely increase to between 2.25% and 2.50%.
Since the 1970s, the Fed has gradually raised its benchmark interest rate by around 25 basis points. However, surging inflation eventually forced it to implement a rate hike last month that was three times bigger than its previous one. This marked the first time in modern history that the central bank had raised its key interest rate by 75 basis points in a row.
What lies ahead
The question is whether the Fed can successfully remove the punch bowl from the financial system. According to David Kelly, a global strategist at JP Morgan Asset Management, the economy's potential to transition from allegro to adagio depends on how the Fed plans its future policy actions.
The Fed must carefully manage the effects of its policy actions on the economy while still keeping an eye on the inflation rate. If the central bank cannot achieve its dual mandate of price stability, it could lose the confidence of financial markets. According to Jerome Powell, the biggest risk to the economy is persistent inflation.
Since the Fed has only avoided recession three times in its history, financial markets are becoming more nervous about the possibility of another recession.
According to a new report by the Bureau of Economic Analysis, Americans' savings rate decreased in May. It showed that the average household saved less than 5% of its disposable income, down from 12.4% a year earlier.
The unemployment rate is at its lowest level in almost 50 years. Despite the various risks the Fed faces, it still has the necessary leeway to raise interest rates thanks to the strong labor market.