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Explainer: The US Federal Reserve’s big move on interest rates

On Wednesday evening, the US Federal Reserve increased US interest rates by a whopping .75%. The move is notable, and should be worrisome, for several reasons. We’ll start with the notable, and move on to the worrisome.

First, it’s vanishingly rare for a central bank to make a move like this without unanimity from its members. The vote at the Fed, as it’s known, was 10-1 in favour of a .75% increase, with one member dissenting, and favouring only a .5% increase in rates.

It’s notable too because this is the single largest increase in interest rates by the US central bank in 28 years. Not since 1994 have rates risen this much in a single go.

These two facts tell us too things: First, that there is deep, deep concern about the US economy amongst monetary policymakers, and second, that there is uncertainty about how to deal with the problem, and the impact of the measures that were announced.

Now, let’s move onto the worrisome. Here is what the Federal Reserve said that their interest rate hike would do to the US economy:

That’s almost a halving of economic growth by the end of the year, which is bad enough, but look at the figure for inflation: It’s almost three times the growth figure.

Here’s a basic rule of macroeconomics, for those of you who didn’t study it: You always want growth to be higher than inflation.

Inflation is not a bad thing, necessarily: When managed well, it is little more than a measure of the expansion of demand in a growing economy. If more people are buying things, and pushing up the price, then that means that things are going reasonably well. This is especially true if growth is higher than inflation: Growth is a measure of how much extra wealth is being created each year. If money is being created faster than prices are rising, then everybody is doing better.

But if prices are rising faster than money is being created, then everybody is doing worse. Everybody’s going to be doing a lot worse by the end of the year, says the Fed.

The problem is that once you get into this cycle of inflation outstripping growth, the only meaningful solution known to man is… a recession. A recession is when economic growth actually turns negative, and the economy shrinks.

This kills inflation over time by reducing demand. Prices come down, but they come down because people can no longer afford to demand products. It is painful, but it works.

But now it’s time to introduce another term, a term for the biggest disaster of all: Stagflation.

Stagflation is a portmanteau of two words: Stagnation, and Inflation. And it is exactly what it sounds like: It’s when inflation continues to persist even after economic growth falls. It’s an economy killer.

It emerges, generally, when inflation is driven by shortages in supply and excesses in demand for goods that are not price sensitive. Think, for example, of oil: Even if the price of diesel goes to a fiver a litre, people still need to travel, still need to get children to school, or get to their jobs. The last proper sustained outbreak of stagflation in the west was, not coincidentally, during the oil price shock of the late 1970s. That shook up the political system on both sides of the Atlantic.

And of course, interest rate hikes themselves are painful: Where the US Federal Reserve goes, the European Central Bank will ultimately follow, even if they follow kicking and screaming. That means higher mortgage payments for people on variable rates, or trackers. It means higher rates on personal and business borrowing. It means the cost of investing in new buildings or facilities for companies rises. The whole point of increasing interest rates is to reduce demand in an economy, and therefore ease inflation. But it’s a painful process, that almost always involves recession or slowdown.

There are, unfortunately, choppy economic waters ahead. Politicians might like to pretend that there’s an easy cure for inflation and the cost of living. Central Bankers, though, are not elected, and they do not have to pretend. There’s only one way out of inflation, and that is to make you, and everyone else, a little poorer. Or, if things go belly up altogether, a lot poorer.

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