BackWhy the Fed isn’t done raising rates as yet
To control steep inflation, the US Federal Reserve has raised the funds rate seven times this year.
PremiumThe US Federal Reserve has increased the federal funds rate by 50 basis points to 4.25-4.5%, the highest in 15 years. Federal funds rate is the rate at which one bank lends to another on an overnight basis. What are the reasons for this increase? Mint examines.
Why has the Fed been raising rates?
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In order to control steep inflation, the US Federal Reserve has raised the funds rate seven times this year. The last four increases before the latest increase were of 75 basis points each. The retail inflation in the US in this cycle peaked at a high 9.1% in June. It has been falling since and was at 7.1% in November. Nonetheless, the rate of inflation is still nowhere near the Federal Reserve’s target of 2%. Further, as can be seen from the chart, while the gap between the funds rate and inflation has narrowed over the past few months, it’s still quite large.
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Is the Fed done raising the funds rate?
While the pace of the increase in rates has slowed, the Federal Reserve isn’t done raising rates as yet. As Jerome Powell, chairman of the Fed, said: “The inflation data received… for October and November show a welcome reduction in the monthly pace of price increases. But it will take substantially more evidence to give confidence that inflation is on a sustained downward path." In fact, the economic projections made by the Federal Reserve suggest that it plans to raise the funds rate to 5.1% in 2023. It had earlier said that it will raise the funds rate to 4.6% in 2023.
So, what exactly is worrying the Federal Reserve?
Despite a slowdown in the US, job vacancies are still very high, with the unemployment rate at a 50-year low. This has been feeding into wage inflation. In order to control this, the Fed will have to keep raising rates to discourage companies from borrowing, expanding and creating jobs. Higher rates will also discourage private consumption and help control prices.
What else has the Fed been doing?
In the aftermath of covid, the Fed had printed and pumped money into the financial system to drive down long-term interest rates and encourage companies and individuals to borrow and spend, and thus push up economic growth. This also led to huge bubbles in stocks, real estate and cryptos. The Fed is now gradually taking this money out of the financial system at the rate of $95 billion per month. With less money going around, long-term interest rates are going up and helping control inflation.
What does all this mean for India?
Higher interest rates in the US encourage investors to move money from different parts of the world, including India, to the US. This puts pressure on other currencies, including the Indian rupee. This dynamic has already been playing out and a weaker rupee makes imported goods expensive and feeds into retail inflation. The US basically ends up exporting inflation to other parts of the world. In this scenario, the RBI may be forced to raise rates further, to slow down the process of deprecation of the rupee.
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5 min read . 27 Sep 2022 Premium Unlocked
