Normally the capital markets appreciate a policy of easy money. But if inflation gets stuck at high levels, it threatens to destabilize the entire economy. In such an environment, stockbrokers are also pinning their hopes on a central bank that will take decisive action against inflation and tighten liquidity. This explains why the markets took the US Federal Reserve's (Fed) unusually large rate hike positively on Wednesday evening.
The major US indices Dow Jones and S
The Federal Reserve raised interest rates by 0.75 percentage points to 2.50 percent on Wednesday. Already in June there was an interest rate step of 0.75 percentage points. "We are determined to bring inflation down," Fed President Jerome Powell said at the press conference on Wednesday evening. The price hike is far too strong.
Powell also said the Fed would significantly reduce its balance sheet, another move to drain liquidity from the system. Like the European Central Bank (ECB), the Fed has an inflation target of 2 percent.
For June, the American statisticians put the price increase in the world's largest economy at 9.1 percent compared to the previous year. It is even higher than in the euro zone, where consumer prices rose by 8.6 percent in the same month. However, the Fed has raised interest rates for the fourth time this year, including Wednesday's move.
In contrast, the European currency watchdogs hesitated until recently to turn the interest rate screw at all. On July 21, the ECB then increased the key rate for refinancing operations from zero to 0.5 percent. For Europeans, it was the first increase in the cost of money in eleven years.
With the latest Fed rate hike, the interest rate differential between the US and Europe has risen again to two percentage points. Higher lending rates usually dampen economic activity and can result in a contraction in economic output.
Powell explained at the press conference that he does not currently see the US economy in a recession, among other things the job market is too strong for that, with an unemployment rate close to a 50-year low. However, he believes a slowdown in economic growth is necessary to bring inflation under control. "Price stability is the foundation of our economy," said the central banker.
Doing too little when it comes to interest rates poses greater risks than doing too much. Further interest rate hikes are to be expected in the coming months, although they do not have to cover all 75 basis points. The Fed's next meeting is in September.
"The current, well-communicated stance of taking firm care of inflation seems the right way to combat excessive inflation and, in particular, inflation expectations," says Christian Scherrmann, US economist at DWS. This leaves the door open for further interest rate hikes of 75 basis points – if the incoming data justifies this.
"Fed Chair Powell has made it clear once again that fighting inflation is a priority, even at the cost of a recession," said Bernd Weidensteiner, an economist at Commerzbank.
Forecasts see the US base rate at the turn of the year at 3.25 to 3.5 percent. It could go up to four percent by mid-2023. Observers expect the key interest rate in the euro zone to be just 1.5 percent in 2023.
Before the 2022 inflationary shock triggered by Russia's war of aggression against Ukraine, America's economy was in better shape than the Euroland economy. The monetary watchdogs therefore assume that America can handle higher interest rates better than the old world.
This also shifts the balance of power between the dollar and the euro. This year, the US currency has already appreciated eleven percent against its European counterpart. For a brief period, the exchange rate even fell below parity, with one euro costing less than one dollar. The euro has not been this cheap since 2002. After the Fed's decision on Wednesday, the European currency was slightly higher than $1.02.
Some experts explain the slightly stronger euro and the rising stock market prices by saying that the Fed has refrained from getting an even bigger mace out of it. After the announcement of the unexpectedly high inflation figure of 9.1 percent, even rumors had spread that 100 basis points were on the table.
"By raising interest rates by 75 basis points, the Fed has taken a step in line with the market," says Michael Heise, chief economist at HQ Trust. He himself considers the chances of a soft landing for the US economy, as Fed Chairman Powell is also envisaging, to be smaller.
A sharp recession, however, is not very likely. In his opinion, too, the interest rate hike is necessary to prevent inflation, which has become more widespread in the USA and encompasses far more than energy and food, from becoming an even bigger problem.
