Fed interest rate increases the way forward for US economy, IMF says

The central bank raised interest rates by 25 basis points earlier this month and indicated that more increases are on the way

A Target shop in Los Angeles. US inflation is still running above the Fed's long-term target of 2 per cent. Getty

Elevated interest rates in 2023 will temporarily increase unemployment in the US but keeping the policy rates high this year is the way forward for the world's biggest economy to create stability and battle inflation, the International Monetary Fund has said.

The rate increases by the US Federal Reserve indicate policy stability and are aimed at bringing the economy back into a state of balance, Andrew Hodge, senior economist in the fund's Western Hemisphere department, said in a research note on Thursday.

"IMF analysis shows that staying the course and keeping interest rates elevated this year will tame inflation," Mr Hodge said.

"Although these higher rates will temporarily increase unemployment, they will pave the way for stable inflation and sustainable economic growth, which will ultimately help create more jobs in the future."

With inflation still hovering close to the 40-year high hit last year and still running above the Federal Reserve's long-term target of 2 per cent, the Fed has been aggressively tightening its monetary policy.

Earlier this month, the central bank raised interest rates by 25 basis points, and indicated that more increases were on the way this year.

This was the Fed's eighth policy rate increase since last year as it seeks to bring down persistently high consumer prices.

The latest increase in interest rates brought the Fed's target range to between 4.5 per cent and 4.75 per cent — about 50 bps away from its end-of-year projection of 5.1 per cent.

Inflation in the US remained elevated on an annual basis in January, boosted by rent and energy prices.

The headline Consumer Price Index (CPI) slowed to 6.4 per cent annually, from 6.5 per cent the previous month, marking the smallest annual increase since October 2021, according to the Bureau of Labour Statistics data.

On a monthly basis, the headline CPI rose 0.5 per cent last month, after increasing 0.1 per cent in December.

Core CPI, which excludes food and energy, rose 0.4 per cent in January and 5.6 per cent annually, data showed.

One significant obstacle in the way of the Fed's efforts to maintain a soft landing for the US economy is the nation's labour market.

The economy added 517,000 jobs in January and unemployment dipped to a new 53-year low of 5.3 per cent.

While the Biden administration has described the latest data as proof of its economic success, Fed chairman Jerome Powell and his colleagues have repeatedly raised concerns that a strong labour market adds to inflationary pressures.

The Fed’s mandate is to achieve price stability and maximum employment, Mr Hodge said.

”The Fed could achieve these goals by raising interest rates to a peak of 4 per cent to 5 per cent, sustaining that for around one to one and a half years, taking into account workers’ strong bargaining position and the high number of vacancies per unemployed worker," he said.

“The higher interest rates would weaken the demand for workers and increase unemployment modestly. This would reduce the pressure for large wage and price increases, particularly in the services sector, helping to lower inflation.”

The US economy is forecast to expand 1.4 per cent in 2023, instead of 1.6 per cent as previously estimated and down from 2 per cent last year and 5.7 per cent in 2021, according to the latest projection from the fund.

The Washington-based lender, which raised its global economic growth estimate for this year by 0.2 percentage points to 2.9 per cent, compared with its October forecast, has warned that the financial environment remains “fragile".

A depreciating US dollar, coupled with global monetary policy tightening, is starting to cool demand and inflation, but the full impact is unlikely to be realised before 2024, the IMF said.