The U.S. Federal Reserve has raised interest rates


Will Australia follow?

The U.S. Federal Reserve (the Fed) voted yesterday to raise interest rates from 0.25% to 0.5%. It is the first time the Fed has raised interest rates since 2018, but it expects to do so six more times this year to reach an interest rate of 2%.

The decision is intended to combat rising prices (inflation).

What’s the FED?

The Fed is the U.S. central bank, equivalent to the Reserve Bank of Australia (RBA).

Central banks are government-owned banks. They usually operate independent of politicians.

They don’t work like normal banks – you can’t set up a personal bank account with the RBA. A central bank’s main ‘customers’ are other banks. So in Australia, NAB, CBA, ANZ, and Westpac have ‘accounts’ with the RBA.

The central bank uses these accounts to change how much money is in circulation. If it wants more money to circulate, it ‘prints’ some and puts it in the accounts of the banks, who then have more to lend to their customers (ordinary people and businesses). If it wants less money to circulate, it buys some back from the banks.

In practice, the way it does this is by changing the interest rate it charges the banks for short-term money loans. A lower interest rate encourages more lending, a higher interest rate encourages more saving.

This interest rate is designed to ‘flow through’ to the rest of the economy. When the central bank charges banks more, banks can ‘pass it on’ by charging customers more on loans and offering them more on savings.

The central bank uses the interest rate as a tool to influence the economy. Low interest rates encourage economic activity and high rates discourage it.

The main reason central banks use interest rates is to manage inflation. If inflation is too high, they raise interest rates to discourage economic activity, which is what the Fed did yesterday.

There are consequences. For example, discouraging economic activity discourages growth in jobs and wages, so central banks have to balance fighting inflation with maintaining a strong economy. The right balance is a topic of fierce debate among economists.

Will Australia follow?

Australia has also experienced some high inflation, and its unemployment rate is at its lowest level since 2008.

So far, the Governor of the RBA, Philip Lowe, has said he will be patient. Speaking at a conference last week, he said that while the RBA might raise rates later in the year, “Australia has the opportunity to secure a lower rate of unemployment than has been the case for some decades” and “moving too early could put this at risk”.

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