US Fed Monetary Policy and Recession
- November 7, 2022
- Posted by: OptimizeIAS Team
- Category: DPN Topics
US Fed Monetary Policy and Recession
Subject: Economy
Context:
Why is the US central bank forcing its economy into recession?
Details:
- 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.
- The Fed has been aggressively raising interest rates since the start of 2022.
Concept
Recession:
Technically, a recession involves the overall output in the 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.
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.
- The Fed Reserve tries to “target” the FFR by controlling the money supply, unlike in India, where the RBI decides what the repo rate.
- If 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.
- If banks borrow at higher rates from each other, they will also lend the money to consumers at a higher rate.
How will increasing the interest rate cause recession?
- To control rising inflation the Fed is raising interest rates sharply- it 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
- Restoring price stability is essential to set the stage for achieving maximum employment and stable prices in the longer run.
- Unless inflation falls rapidly, the Fed will likely continue to hike the FFR for the next few months– exacerbating the chances of the economy going into recession.
How does raising the interest rate tackle inflation?
- Reduce Aggregate Demand-US is growing rapidly post pandemic-a genuine “V-shaped” recovery. Higher interest rates tend to tamp down such excessive demand by increasing cost of borrowing.
- Keep longer-term inflation expectations anchored- ie 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 and employers (firm owners) raising prices to pay higher wages causing the wage-price spiral.