At the New York Stock Exchange as the Federal Reserve makes an announcement regarding interest rates in on November 2. (AP)
Dear Readers, On November 8 (Tuesday), the US will hold mid-term elections for the US Congress, which constitutes the House of Representatives and the Senate. They are called “mid-term” elections because they happen in the middle of a President’s four-year term. They are crucial not just because of the churn they can bring among the lawmakers — all the seats in the House of Representatives and one-third of the seats in the Senate are up for grabs — but also for what the results may say about the prospects of the Biden presidency. While many issues dominate the agenda — from abortion rights to immigration controls — the state of the US economy is likely to be a decisive factor. The US has been facing historically high inflation rates even though its unemployment rate is at historic lows. What complicates the matter is that the actions of the US central bank — the Federal Reserve (or Fed) — threaten to push the world’s largest economy into a recession. Last week the Fed yet again raised interest rates for the US economy. The Fed has been aggressively raising interest rates since the start of 2022. So much so that now it is almost a foregone conclusion that the US economy will go into a recession either in 2023 or 2024. Technically, a recession involves the overall output in the US economy contracting in two successive quarters but broadly speaking it refers to a prolonged period of economic contraction coupled with job losses, falling incomes and reduced expenditures. The Fed’s actions raise several questions: 1: Why is the US Fed doing something that will inflict such an economic hardship on its own people? 2: How long will the Fed continue to raise rates? 3: How will hiking interest rates bring down the price of crude oil? In a press conference, Fed Chairman Jay Powell tried to explain many of these questions. But before anything else, here’s a quick introduction to the Federal Funds Rate that the Fed has raised by 3.75 percentage points since the start of 2022. What is the Federal Funds Rate (FFR) and how does the US Fed tweak it? The FFR is the interest rate at which commercial banks in the US borrow from each other overnight. Arguably, if banks borrow at higher rates from each other, they will also lend the money to consumers at a higher rate. Now, unlike in India, where the RBI decides what the repo rate (or the interest rate at which RBI lends money to banks) will be, in the US, the Fed can’t directly specify the FFR. Instead, it tries to “target” the FFR by controlling the money supply. So when the Fed wants to raise the prevailing interest rates in the US economy, it reduces the money supply. This forces every bank in the economy to charge higher interest rates. The process starts with commercial banks charging higher interest rates to lend to each other for overnight loans. How does raising interest rates cause recessions? Although it is rather simplistic, the following analogy can prove to be quite useful for a lay reader. Imagine the economy to be a car and the central bank to be the driver who is charged with the job to maintain a certain ideal speed of the car. When the car is running too slowly (say, unemployment is high and growth is faltering), the central bank can press on the accelerator by lowering the interest rates in the economy. This leads to stimulating overall spending and economic activity; lower interest rates disincentivise keeping money in savings bank accounts while making fresh loans cheaper. When the car is running too fast (say, inflation soars), the central bank eases off the accelerator and presses the brakes — that is, raises interest rates to incentivise savings instead of expenditure. Reduced aggregate demand thus cools down the economy (i.e. slows down the car). Now, imagine a scenario when the car is moving uphill and while the central bank is speeding up, it encounters a sudden obstacle. It would be forced to immediately jam on the brakes. This would make the car not only come to a sudden standstill but also move back a bit if it is on an incline. The Fed raising interest rates so sharply resembles a sudden jam on the brakes. Such a sharp increase in interest rates makes people postpone their purchases and instead incentivises them to keep their money in banks to earn better returns. The reduced demand results in fewer jobs, a fall in incomes and reduced overall output. So, why is the US Fed doing something that will inflict such an economic hardship on its own people? Simply put, the answer is: to restore price stability in the economy. The US is facing historically high inflation levels (often in double digits) and the Fed wants to revert to its target rate of 2%. “My colleagues and I are strongly committed to bringing inflation back down to our 2 per cent goal. We have both the tools that we need and the resolve it will take to restore price stability on behalf of American families and businesses. Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labor market conditions that benefit all,” stated Powell during the press conference. To be sure, Powell was aware of the consequences of the Fed’s decision: “Reducing inflation is likely to require a sustained period of below-trend growth and some softening of labor market conditions. Restoring price stability is essential to set the stage for achieving maximum employment and stable prices in the longer run. The historical record cautions strongly against prematurely loosening policy. We will stay the course, until the job is done". How long will the Fed continue to raise rates? The Fed’s target is to get the inflation rate down to 2%; in September it was at 8.2%. The Fed has already raised the interest rate to 4%. Chair Powell set out three questions that help one understand how the Fed is thinking about the tighter monetary policy stance. “I think you can think about our tightening program as really addressing three questions: 🔴 the first of which was and has been, how fast to go, 🔴 the second is how high to raise our policy rate, and then 🔴 the third will be, eventually, how long to remain at a restrictive level,” he stated. On the first issue of speed, the Fed has already sped from a range of 0%-0.25% target of FFR at the start of the year to 3.75%-4%. “It's a historically fast pace and that's certainly appropriate given the persistence and strength in inflation and the low level from which we started,” he said. Then comes the issue of the so-called terminal rate of FFR. Many expect the Fed to continue raising the FFR until it reaches 5.5%. Powell did not specify the terminal rate stating that “That level is very uncertain though, and I would say we're going to find it over time”. But he did say that the Fed will raise the rate “to a level that's sufficiently restrictive” to bring inflation to our 2 per cent target over time. He, however, made it amply clear that “It's very premature in my view to think about or be talking about pausing our rate hike”. In other words, unless inflation falls rapidly, Fed will likely continue to hike the FFR for the next few months. “So, I would say, as we come closer to that level, move more into restrictive territory, the question of speed becomes less important than the second and third questions,” stated Powell. A key element here is to understand that there are considerable lags when it comes to monetary policy. Unlike a car in which pressing on the brakes is likely to yield an immediate result, real-life policymaking is hampered by several factors. “Of course, with the lags between policy and economic activity, there's a lot of uncertainty so we note that in determining the pace of future increases, we'll take into account the cumulative tightening of monetary policy as well as the lags with which monetary policy affects economic activity and inflation,” he announced. How will hiking interest rates bring down the prices of crude oil and other such commodities that are fuelling inflation? This is a question which is asked of Chair Powell almost at every meeting. In the past, the Fed has accepted that it has no tools to directly bring down the prices of commodities. But, at the same time, Powell has explained why the Fed continues to raise interest rates. There are two parts to the explanation. For one, unlike many other countries that are simply seeing inflation surge due to supply constraints, the US also has a problem of excessive demand. That’s because the US grew very rapidly — a genuine “V-shaped” recovery — as it came out of the pandemic. Higher interest rates tend to tamp down such excessive demand. Two, by raising interest rates, the Fed is trying to “keep longer-term inflation expectations anchored and keep the public believing in 2 per cent inflation”. While it is true that the Fed can’t directly bring down commodity prices by raising interest rates, it can still ensure that people don’t lose faith that prices will remain stable. If people stop believing that inflation will, at least in the medium term, come back to the 2% target, then they will ask for higher wages. That, in turn, will lead to employers (firm owners) raising prices to pay higher wages. This can become a vicious loop. Until next time, Udit If you received this newsletter as a forward, you can subscribe to it, here. Do read our other Explained articles, here | To subscribe to our other newsletters, click here | 
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