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Why did the Fed raise the funds rate?

The federal funds rate is the interest rate at which banks lend money to other banks on an overnight basis. By raising this rate, the Fed tries to push up short to mid-term rates in the economy. The idea is to make borrowing expensive for both consumers as well as firms. At higher interest rates, consumers are less likely to borrow and spend money. Also, with rates on savings rising, consumers are likely to postpone consumption. This helps rein in demand and less money chases goods and services; in the process, the rate of price rise or inflation comes down. Retail inflation in the US has been over 8% since March.

How do higher interest rates impact firms?

At higher interest rates, borrowing becomes expensive. Companies borrow less and invest less, creating fewer jobs. Hence, wages grow at a slower pace and the overall retail inflation comes down. At least that’s how it’s supposed to work in theory. Higher interest rates have started to push down consumer demand. Take the case of housing sales. During the July to September period, the median sales price of houses sold in the US rose by 10.6% annually. During the same period last year, prices had risen at a much faster 21.8%. But a similar impact is yet to be seen when it comes to wage inflation.

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What’s up with wage inflation in the US?

As Jerome Powell, the chairman of the US Fed, said: “The labour market remains extremely tight, with the unemployment rate at a 50-year low... and wage growth elevated". High wage inflation feeds into retail inflation as employees continue to demand higher salaries and the companies are forced to pass on this higher cost to end consumers.

So, what’s the way forward for the Fed?

Some experts have argued that the Fed might be overtightening, that is, raising rates higher than required. Powell doesn’t buy this, given that inflation remains elevated and the fact that the federal funds rate is still much lower than the rate of inflation. In this scenario, it is highly likely that the Fed will continue to raise interest rates longer than it had originally envisaged. As the Fed chairman put it: “Reducing inflation is likely to require a sustained period of below-trend growth."

How will this impact the world at large?

With interest rates rising in the US, money is likely to move from other parts of the world to the US. As money moves, the dollar will continue to gain in value against currencies such as the Indian rupee, the Thai baht, the euro, and the British pound, which will continue to lose value. This will make imports expensive for these countries. In the process, as the US tries to control domestic inflation, it will continue exporting inflation to other parts of the world.

Vivek Kaul is the author of Bad Money.

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