The Federal Reserve kept interest rates on hold at close to zero last week. With inflation rates increasing, analysts believed there was an outside chance that the Fed would increase the base rate.
Instead, they said that the inflation the country was experiencing was largely reflecting transitory factors. In a statement, it said that although employment had strengthened, “risks to the economic outlook remain in place.” It warned that the path of the economy remained largely dictated by the course of the virus.
US inflation rates continued to rise in May, largely driven by increased demand for used vehicles and energy as the country returns to normality after restrictions and lockdowns that halted much of its economic activity.
An increase in interest rates would have driven the cost of borrowing up for businesses and consumers. Under normal circumstances, the 5% inflation that the country has experienced in the year up to the end of May, would likely have prompted an interest rate increase.
The 5% increase is the largest year-on-year increase since August 2008.
Keeping interest rates held at their current level is seen as an acknowledgment that the US, and the rest of the world, are not out of the woods yet as far as a full economic recovery goes.
What is inflation and why does it matter?
Inflation is simply the rate at which the prices for goods and services increase. It is one of the pillars used for assessing the economic status of a country. Too much inflation reduces the spending power of the consumer and causes a fall in the standard of living.
However, a little inflation is seen as helpful to an economy. Consumers are encouraged to keep spending if they believe that prices will increase over time. For this reason, most nations try to achieve a balance when it comes to taking measures to manipulate the rate, with most aiming for 2% as the benchmark figure.
The problems occur when prices rise too sharply. This is seen as a sign of a struggling economy where demand is outstripping supply. In these circumstances, an increase in interest rates can be used as a “brake” designed to slow inflation.
Raising interest rates causes an increase in the cost of borrowing including mortgage payments, loans, and credit card repayments. This results in a reduction in consumer demand and the “supply and demand chain” normalizes and inflation reduces.
In this instance, the Federal Reserve sees the current rate of inflation as being merely transitory and as a result of unprecedented circumstances.
For many analysts, it eases worries that rising inflation would have forced the Fed’s hand into raising interest rates. They had cited concerns that raising interest rates too quickly would have had a dampening effect on the economy’s recovery.
The Fed’s move is seen as an attempt to ease those worries, stating that it was – “committed to using its full range of tools to support the US economy in this challenging time”.