FEDERAL FUND RATE (FFR)
In ITS continuing bid to cool down inflation in the US at a four-decade high of
WHAT IS THE FFR?
It is the interest rate at which commercial banks in the US borrowed from one another overnight.
The US Fed can’t directly specify the FFR, but it tries to target the rate by controlling the money supply.
When the Fed wants to raise the prevailing interest rates in the economy, it reduces the money supply, thus forcing every lender in the economy to charge higher interest. The process starts with the commercial banks charging higher to lend to one another for overnight loans.
WHY IS THE FED TIGHTENING THE MONEY SUPPLY?
Any central bank resorts to monetary tightening when it wants to rein in inflation in the economy, by decreasing the amount of money, as well as raising its price (interest rates), the Fed hopes to dent the overall demand in the US economy. Reduced demand for goods and services is expected to bring down inflation.
Aggressive monetary tightening like the one currently underway in the US – involves large increases in the interest rates in a relatively short period, and runs the risk of creating a recession.
9.1% in June –the Federal Reserve raised the Federal Fund Rate target by another 75 basis points.
The aggressive monetary stance was the main reason why the US economy‘s GDP contracted for the second consecutive quarter.
WHAT IS A RECESSION AND IS THE US CURRENTLY FACING ONE?
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.
Latest data released by the US Bureau of Economic Analysis, the country’s GDP contracted by 0.9% in the second quarter of 2022. sine the GDP had already contracted by 1.6% during the first quarter this implies the US is in recession
WHY DO THEY CONTEST IT?
A massive point of contradiction is the remarkable job creation in the first half of 2022.Notwithstanding the Fed’s aggressive monetary tightening the labour market remains quite tight- that is unemployment is still at historic lows.
In fact, despite two successive quarters of GDP contraction, the US economy created around 2.7 million new jobs in the first half of 2022. This is why Fed chairman Jay Powell refused to characterize the US economy as one undergoing a recession.
WHAT IS THE NATIONAL BUREAU OF ECONOMIC RESEARCH DEFINITION?
The NBER’s traditional definition of a recession is “it is a significant decline in economic activity that is spread across the economy and that lasts more than a few months
The NBER gives several reasons for not accepting a two-quarters definition.
1) We do not identify economic activity solely with real GDP, but consider a range of indicators.
2) We consider the depth of the decline in economic activity. Thus real GDP could decline by relatively small amounts in two consecutive quarters without warranting the determination that a peak had occurred.
3) Our main focus is on the monthly chronology, which requires consideration of monthly indicators.
4) In examining the behaviour of production every quarter, where real GDP data are available, we give equal weight to real GDI
GDI- refers to gross domestic income; this is also a measure of national income albeit from the income side of the economy as against the GDP, which looks at the expenditure side of the economy.
According to NBER, the difference between GDP and GDI called Statistical discrepancy- was particularly important in the recessions of 2001 and 2007-2009.
WHAT IS THE OUTLOOK FOR THE US ECONOMY?
The US economy is facing a curious situation –inflation at a four-decade high and at the same time, the unemployment rate at a five-decade low.
The monetary tightening has already resulted in GDP contraction in two successive quarters. But inflation rate is still much higher than the Fed’s target rate of 2%
As such, if the inflation rate does not moderate fast enough, one should expect more rate hikes in the rest of the year. If that happens one should expect more demand destruction and a deeper recession.
WHAT IS LIKELY TO IMPACT ON INDIA
Rising rates in the US were one of the main reasons for money flowing out of India and leading to the rupee depreciating against the dollar
If the Fed carries on hiking rates, the RBI will be forced to do the same to protect the rupee. But that will come at the cost of domestic economic growth.
