Baba’s Explainer – US Fed Reserve Hike

  • IASbaba
  • July 30, 2022
  • 0
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  • GS-3: Economy & challenges
  • GS-2: International Events & its impact on India

Context: In its continuing bid to cool down raging inflation in the United States — at 9.1% in June, the inflation rate is at a four-decade high — the Federal Reserve or Fed (US’ central bank) decided to raise the Federal Funds Rate target by another 75 basis pushing the rate from zero to almost 2.5% now.

What is the Federal Funds Rate (FFR)?
  • The FFR is the interest rate at which commercial banks in the US borrow from each other overnight (recall call money rate)
  • The US Fed can’t directly specify the FFR but it tries to “target” the rate by controlling the money supply.
  • As such, when the Fed wants to raise the prevailing interest rates in the US economy, it reduces the money supply, thus forcing every lender in the economy to charge higher interest rates.
  • The process starts with commercial banks charging higher to lend to each other for overnight loans.
Why is the Fed tightening money supply?
  • This is called monetary tightening, and the Fed (or any other central bank, for that matter) resorts to it when it wants to rein in inflation in the economy.
  • By decreasing the amount of money, as well as raising its price (the interest rate), the Fed hopes to reduce the overall demand in the economy.
  • Reduced demand for goods and services is expected to bring down inflation.
What are the risks of monetary tightening?
  • Aggressive monetary tightening — like the one currently underway in the US — involves large increases in the interest rates in a relatively short period of time, and it runs the risk of creating a recession.
    • The most common definition of recession requires the GDP of a country to contract in two successive quarters. Contracting GDP typically results in job losses, reduced incomes, and reduced consumption.
    • Since the US GDP has already contracted by 1.6% during the first quarter (January, February and March) of 2022, a contraction in the second quarter will imply the US is in recession
  • This is called a hard-landing of the economy as against a soft landing (which essentially refers to monetary tightening not leading to a recession). The chances of a soft-landing for the US exist but are extremely low.
How have other countries reacted to US hiking interest rate?
  • In what is being seen as a reverse currency war, most central banks across the world are trying to raise their interest rates to counter the Fed’s actions and ensure their respective currency claws back value against the dollar.
  • There are three key terms that one is likely to hear repeatedly in the coming days: Yield inversion, soft-landing and reverse currency war.

Bond yield curve inversion

  • A yield curve illustrates the interest rates on bonds of increasing maturities.
  • An inverted yield curve occurs when short-term debt instruments carry higher yields than long-term instruments of the same credit risk profile.
  • Inverted yield curves are unusual since longer-term debt should carry greater risk and higher interest rates, so when they occur there are implications for consumers and investors alike.
  • An inverted yield curve is one of the most reliable leading indicators of an impending recession.

Soft Landing

  • A soft landing is a cyclical slowdown in economic growth that avoids recession.
  • A soft landing is the goal of a central bank when it seeks to raise interest rates just enough to stop an economy from overheating and experiencing high inflation, without causing a severe downturn.
  • Soft landing may also refer to a gradual, relatively painless slowdown in a particular industry or economic sector.
  • But when the actions of the central bank bring about a recession, it is called a hard-landing.

Reverse Currency War

  • A flip side of the US Fed’s action of aggressively raising interest rates is that more and more investors are rushing to invest money in the US.
  • This, in turn, has made the dollar become stronger than all the other currencies.
  • Every central bank is trying to figure out ways to counter the US Fed and raise interest rates themselves in order to ensure their currency doesn’t lose too much value against the dollar.
  • That’s because a currency which is losing value to the dollar, on the other hand, finds that it is getting costlier to import crude oil and other commodities that are often traded in dollars.
  • But raising the interest rate is not without its own risks. Just like in the US, higher interest rates will decrease the chances of a soft-landing for any other economy.
What is the outlook for the US economy?
  • The US economy is facing a curious situation. One the one hand, it faces an inflation rate that is at a four-decade high and, on the other, its unemployment rate is at five-decade low
  • However, aggressive monetary tightening of the kind being witnessed will likely result in a recession sooner rather than later.
  • The US inflation rate is at over 9% and the Fed’s target inflation rate is 2% — that’s a gap of 7 percentage points. Historically, every time the Fed has tried to bring down inflation by more than 2 percentage points, the US has witnessed a recession.
  • The ongoing inversion of the bond yield curve is another robust predictor of a recession in the offing. The yields on 2-year, 5-year and 10-year US bonds were 2.97%, 2.83% and 2.78%, respectively.
What is the likely impact on India?
  • News of a hike in interest rate in the US leads not only to an outflow of funds from equities into US treasury bonds, but also to an outflow of funds from emerging economies (like India) to the US.
  • The rupee is also expected to come under pressure as the dollar strengthens.
  • In the latest — July update of the — World Economic Outlook, the IMF has downgraded the growth projections for the US, China and India. “Downgrades for China and the United States, as well as for India, are driving the downward revisions to global growth during 2022–23, which reflect the materialization of downside risks highlighted in the April 2022 World Economic Outlook,” it states.
  • A global slowdown is unlikely to have any positives for India apart from some relief in crude oil prices.
  • The IMF has knocked off almost a full percentage point each (0.8%, to be precise) off India’s GDP projections for the current year and the next.
  • “For India, the revision reflects mainly less favorable external conditions and more rapid policy tightening,” explains the IMF.

Mains Practice Question – How does US Fed rate hike impact the global economy?

Note: Write answers to this question in the comment section.


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