Federal Reserve’s 0.25% Rate Hike Announces a New Era for the US Economy

The Federal Reserve’s committed to its planned interest rate hike. The first increase was announced today by 0.25%, possibly leading the US economy into a new cycle. However, macroeconomic and geopolitical conditions are not quite the same as with previous cycles.

Covid-19 Changed How Federal Reserve Controls Inflation

One of the major objectives of the Federal Reserve is to control the rate of inflation in the US. However, the Covid-19 outbreak made this cycle different than previous ones. This is quite apparent when viewing the Federal fund’s effective rate vs. inflation chart below.

As the chart shows, Fed’s fund rate typically increases when there is high inflation. Specifically:

• February 1980 marked the beginning of a recession with an inflation rate at 14.2% and the Fed funds rate at 15%.

• After inflation lowered to 12.6% in November, the Federal fund rate lowered from 20% to 18%.

• In November 1982, the recession ended. The Fed started increasing the fund’s rate by 1 point, three times from December 1981 to March 1982, from 12% to 15%.
  
  
• As the inflation began to subside, the Fed funds rate followed from 15% to 8.5% in December 1982, with inflation having subsided to only 3.8%.

Clearly, the start of the Covid-19 pandemic in 2020 was an aberration, when the Fed took such unprecedented steps as to buy at least $500 billion in Treasury securities, in addition to $200 billion in government-guaranteed mortgage-backed securities. It was a period of all hands on deck to bolster all sectors of the economy.

For comparison, in 2020 alone, the Fed’s $2.3 trillion injection completely overshadowed its intervention during the Global Financial Crisis of 2008 by a factor of at least 4x. Fast forward to trillions more in the next two years and inflation chickens have come home to roost.  In November 2021, even Deutsche Bank told its investors that the Fed’s monetary policies could “create a significant recession“.

Did the Federal Reserve Devalue the Dollar with the Rate Hike?

During the pandemic, the Federal Reserve flooded the economy with cash by buying up assets, greatly lowering the risk for corporations. The purpose of having near-zero interest rates was to stimulate the economy by borrowing at a discount. However, the side effect is the largest increase in the price of consumer products and services in the last 40 years, aka inflation.

Following the economic law of supply and demand, the more there is of an economic unit, the less value it has. This is best exemplified by the difference between Bitcoin (BTC) and Dogecoin (DOGE). The former is eternally limited to only 21 million coins, while the latter has 132 billion coins with an annual inflation rate of 5 billion new DOGE coins.

That is the difference between one DOGE worth $0.11 and one BTC worth $40,000. With 35% of all US dollars in existence “printed” in just 2020, it then follows that the dollar is devalued. This devaluation manifests as inflation, exhibited as buying less with more dollars.

As last accounted for by the Bureau of Labor Statistics on March 10, all items Consumer Price Index (PCI) increased by 7.9% over the last 12 months, not accounting for seasonal adjustment.

The visceral experience of seeing prices rise every week is a significant political liability. Hence, why the Fed is starting to increase its fund’s rate this March.

The question is, has the market already accounted for this new macroeconomic environment when borrowing becomes more expensive?

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Is the American Economy Heading for Another Recession?

From the first chart in this article, you may have noticed that the Fed has historically been increasing and decreasing rates by whole percentage points. Certainly, not by quarters of a point – 0.25% as of March’s first increase.

Is this a commensurate step with 40-year high inflation? By the Fed’s own record, it isn’t. However, the Fed is left with tiny space to maneuver because it habituated the markets to be strongly dependent on it. When one is addicted to cheap borrowing for so long, what is the consequence of pulling the rug?

The consequence is likely a recession, which the Fed is trying to avoid with minuscule 0.25% interest rate hikes which are highly unlikely to put a damper on inflation. After all, it was the very announcement of interest rate hikes that caused both crypto and stock market downturns in the last couple of months.

Furthermore, the string of external factors at play right now is quite historic. Among them is the depleted economic activity from C19 lockdowns, the resulting supply chain disruptions, and the most significant of all, the economic fallout from the Russia-Ukraine conflict notably in terms of oil and energy. Some major countries are also considering using non-USD currencies for oil payments, which could degrade USD from its global reserve currency status.

Much of the Fed’s sustenance and off-loading the costs of its monetary policies have been reliant on the status of the dollar as the world’s global reserve currency. Now that India, the world’s third-largest oil consumer, considers buying Russian oil at a discount via a rupee-ruble bridge, that status is about to change. Likewise, Saudi Arabia is considering China’s yuan instead of the dollar for its oil shipments.

With such a historic status potentially removed from the dollar, the Fed will have even less maneuvering space to enact monetary policies of the scope it did in the past. For the end consumer, that means increased inflation, leading toward recession if it remains above nominal wage growth.   

Do you think the rate hikes are an effective solution for controlling USA’s inflation? Let us know in the comments below.