Interest Rates That Don’t Work

The U.S. Federal Reserve has raised the key interest rate for the 10th time in a row. This puts struggling banks at risk. It has barely helped combat inflation thus far.

Federal Reserve Chair Jerome Powell seemed a little desperate Wednesday at the press conference that followed the Fed’s meeting. The Fed has raised interest rates by more than 5% in just 14 months, according to Powell. And yet, “The unemployment rate remained very low in March, at 3.5 percent.” [https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20230503.pdf] [WV verified] A historically low level. It is indeed remarkable.

To combat the highest inflation in decades, Powell and his Fed colleagues yesterday raised the key interest rate for the 10th time in a row, by a quarter of a percent again, as with the previous Fed decision in March. Just a little over a year ago, the key interest rate was close to zero; now it lies between 5% and 5.25%. The Fed last cranked up interest rates this quickly in the ’80s under Powell’s predecessor Paul Volcker.

It would therefore have been expected at the least that the job market would cool. Instead, only a few hours before the Fed’s meeting came the report that American companies created 296,000 new jobs in April. The data comes from the customer data of ADP, a service provider that helps companies with personnel management. This was twice as many new jobs in the private sector as in the previous month of March.

There is still a worker shortage in the U.S., and Powell fears that scarce supply will drive wages, and thus ultimately prices, sky high. At least the number of open positions has recently fallen to 9.6 million. There are still almost two open positions for every job seeker in the country. However, Powell, who used to work on Wall Street, ought to recall the saying that is so popular there: “The trend is your friend.” His hope: The job market cools without unemployment rapidly rising. However, “That would be against history,” as Powell himself conceded on Wednesday.[https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20230503.pdf] [WV verified]

The Fed Itself Could Have Contributed To the Inflation Dilemma

The Fed chair and his colleagues must deal with the accusation of having personally contributed to the dilemma. In the fall of 2021, Powell and his colleagues insisted that rising inflation would only be “temporary.” [https://www.federalreserve.gov/newsevents/speech/powell20210827a.htm] [WV verified] That’s how they missed the opportunity to intervene at a point in time that would have been less painful. The Fed bankers would have made themselves unpopular in doing so because they would have choked an economy that was only just starting to strengthen again. The course correction has now proven difficult.

The surge of inflation is attributed to disrupted supply chains during the pandemic. When the economy bounced back, a constricted supply was suddenly met with explosive demand. The Russian invasion of Ukraine additionally tightened the supply of natural gas and oil. Prices rose as a result. However, shortages have abated since then, and energy prices have also come down from peak highs. But many companies are taking the opportunity to raise their prices, not just to mitigate costs, but also to increase their profits.

This could be one cause of the still-high rate of rising prices in both the U.S. and Europe. In the U.S., the construction sector is a determining factor for the economy. And as Powell noted at the press conference, increasing interest rates have severely restricted housing construction. However, other areas seem less sensitive to interest rates, such as infrastructure construction. Joe Biden’s administration calls for and promotes domestic industry production, which will result in the construction of new factories all over the country. The industry’s commission books are full, The Wall Street Journal reports, in some cases for years to come.

Higher Interest Rate Could Become Driver of Inflation

And there is still the banking crisis on top of that. Beginning with the collapse of Silicon Valley Bank, there are now three banks that have been shut down by regulators. This is no credit to the Fed, which, after all, performs oversight of banks. This is particularly putting the regional institutes under pressure. Lending is likely to decline as a result.

In his remarks on Wednesday, Powell made it sound like this could contribute to the economy cooling. However, scarcer loans and higher interest rates could turn out to be drivers of inflation. And if it goes really badly, even more banks will get into trouble. Powell emphasized at the press conference that the American banking system is “sound.” [https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20230503.pdf] [WV verified] However, the market price of PacWest, a California regional bank, fell by more than 40% on Wednesday after the stock market closed. We still don’t have a financial crisis, but that could quickly change. Given the unclear signals from the economy, Fed officials have decided to wait and see for now. At least that is what their wording suggested on Wednesday. It is sure to be a very tense break.