Why is US Federal Reserve forced to raise rates?

The US Federal Reserve, commonly known as "the Fed," has raised interest rates by 75 basis points for the third time this year.

The highest level of inflation experienced in the US in over 40 years has prompted the Fed to take aggressive action. The rate hike on Wednesday brings the benchmark interest rate up to a range of 3.0% to 3.25% from 2.25% to 2.50%.

The dollar's value, which has been consistently rising against the euro for around a year since the European Central Bank responded far more slowly to rising inflation, increased in the minutes following the announcement to a fresh 20-year high against Europe's single currency.

At successive meetings throughout the year, the leaders of US Federal Reserve banks have indicated they will continue to pursue more rate hikes, potentially holding the benchmark rate above 4% for an extended time as inflation persists.

US Federal Reserve Chairman Jerome Powell warned against "prematurely" lowering rates again in a speech soon after the announcement.

In August, Powell had said that the Fed would continue raising interest rates until it was "confident the job is done."

Powell admitted the rate hikes would also "bring some pain to households and businesses."

"These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain," he said.

Inflationary pressures in Europe have also prompted the European Central Bank to also raise interest rates, albeit so far less aggressively and far more slowly than in the US.

Why is the Fed forced to raise rates?

Simply put, inflation means a dollar buys less than what it used to. A common measure of inflation is the Consumer Price Index (CPI), which compares the average cost of certain goods over a specific time frame to the previous year.

Weeks after Powell's speech, the CPI data for August ended up showing an 8.3% year-on-year increase, which was higher than the market forecasts of 7.9% to 8.1%.

Although the August CPI data was lower than the over 9% peak seen in June, it also indicated that inflation is not tapering off quickly. Markets, which had hoped for a rosy inflation report ushering in a dovish Fed response, plummeted in anticipation of more aggressive policy.

The current inflation has been attributed to several factors including supply issues amid a post-pandemic boom in consumer spending and the fallout from Russia's war in Ukraine. Some hope these factors should prove transitory, meaning the inflation need not necessarily be permanent.

The Fed has also been criticized for contributing to inflation with loose economic policy like keeping interest rates too low for too long, and for continuing to inject money into the economy.

Most Western central banks dropped their rates to unprecedented levels at or near zero in the aftermath of the financial crash, and then kept them in that ballpark for the better part of 15 years.

Why raising interest rates is thought to tame inflation

Economic tightening by increasing the cost of borrowing money by raising interest rates is a tool central banks can use to cool off the economy by lowering demand. The idea is to discourage borrowing and spending. One of the Fed's central tasks is maintaining "price stabilization."

However, aggressive rate hikes also run the risk of ushering in a recession, as overall economic growth is also dampened.

Powell has touted the idea of a "soft-landing," which means inflation can be brought under control without kneecapping the economy.

However, some critics have said this is wishful thinking, as interest rates would have to far exceed current levels to bring inflation down to a target of 2%.

The last time inflation was this high was in 1980, with a peak of over 14%. Then-Fed chairman Paul Volcker at one point in 1981 raised interest rates to over 20% in order to beat back double-digit inflation, unleashing a deep economic recession.

In August, Powell also indicated that the Fed would be willing to accept recession in order to bring inflation under control. However, although it is hard to predict where inflation will go from here, Powell is not expected to go as far as Volcker.