Ending a ten month streak, the Federal Bank decided on June 25 that it would no longer reduce the interest rates, thereby indicating a shift of concern to inflation. For the past many months, the U.S. economy has not only been facing inflationary pressures but experiencing grave threats to its growth prospects.
While the former may be attributed to the surging energy prices across the world, the latter is due to bursting of the housing bubble and the credit crunch. In an attempt to keep the economy afloat, the Fed started reducing the interest rate since last September, slashing it from 5.25 per cent to a record low of 2 per cent. By lowering the interest, the Fed wanted to encourage borrowing in the economy and thus increase spending, thereby preventing the economy from going into a possible phase of recession. Therefore till now, the Fed diverted a majority of its efforts in strengthening the economy, rather than checking inflation. However, the Federal Open Market Committee (FOMC) and Fed chairman, Bernanke, felt that the interest rates were low enough to keep the economy going and inflation posed to be a larger risk now.
So the FOMC justified their action of refraining from reducing the rates by stating, “Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased.” This statement certainly gave the market a sense of confidence as the U.S. stock market indices closed on a positive note.
If the Fed wanted to check inflation any further, it would then have to reduce the money supply in the economy by raising interest rates and consequently, try to control the quantity demanded in the market by curbing expenditure. But then again, this would also raise unemployment. It seems that the Fed is caught between a rock and a hard place. Despite numerous attempts by the Fed, the unemployment rate shows no signs of slowing down; neither do the crude oil or the commodity prices. Even the housing sector seems bleak. Clearly, the Fed has a long way to go before it can see the silver lining on this black cloud.