May 16, 2022

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US inflation is at a 40-year high

US inflation is at a 40-year high

An American worker distributes food at a grocery store in Fairfax, Virginia.Statue Olivier Toulory / AFP

Inflation in the United States rose to a 40-year low of 7.5 percent in January. Inflation can be seen throughout the economy, showing major inflation. The measure, which does not take into account volatile energy and food prices, came in at 6 percent.

The surprisingly high number is giving the US Federal Reserve a headache. Not only is inflation above the 2 per cent target, it is also on an upward trend. Inflation was 7 percent in December.

There are various reasons for the rise in prices. The government’s massive financial stimulus late last year has boosted the economy, US consumers have increased their spending and manufacturers continue to struggle with supply chain problems. In addition, a tight labor market means employers have to pay higher wages to find and retain employees, after which they pass on to clients.

Drastically raising interest rates

The Federal Reserve (Fed) plans to raise interest rates in March for the first time in three years. The reason behind this is that borrowing and investing will reduce the demand for more expensive products and services. It should translate into lower prices or at least slower rising prices.

Now the question arises as to how big that intervention should be. Until recently, financial markets were expected to raise interest rates by 0 to 0.25 percent. Later this year, the central bank will raise its key rate four more times by 25 basis points. But now many economists see it as too low and too slow. They are calling on the central bank to immediately raise interest rates to 0.5 per cent in March, after which it may raise another 50 basis points.

In the world of central banks, this is exceptionally high. Policymakers generally want to avoid compressing a well-functioning economy with very large interest rate hikes. Two small steps with 25 base points instead of one big jump in the unknown. This will make the difference between a hard and a smooth landing.

At this point, however, ING researcher James Knightley believes a clear signal is needed. The central bank needs to make it clear to citizens, investors and companies that it is serious about fighting inflation. “The central bank should be aggressive,” Knightley said. “It is now true that he is showing his commitment by raising interest rates by 50 basis points in March.”

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