FEDERAL FUNDS RATE (FFR)
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- On one hand, US is experiencing a four-decade high inflation rate and, and on the other, its unemployment rate is at five-decade low. Thus, to cool down raging inflation in the United States— the Federal Reserve or Fed (US’ central bank) decided to raise the Federal Funds Rate target by another 75 basis points.
What is the Federal Funds Rate (FFR)?
- The FFR is the interest rate at which commercial banks in the US borrow from each other overnight.
- The US Fed can’t directly specify the FFR but it tries to “target” the rate by controlling the money supply.
- As such, when the Fed wants to raise the prevailing interest rates in the US economy, it reduces the money supply, thus forcing every lender in the economy to charge higher interest rates.
- The process starts with commercial banks charging higher to lend to each other for overnight loans.
Why is the Fed tightening money supply?
- Reducing money supply is called monetary tightening, and the Fed (or any other central bank, for that matter) resorts to it when it wants to rein in inflation in the economy.
- By decreasing the amount of money, as well as raising its price (the interest rate), the Fed wants to reduce overall demand in the economy. Reduced demand for goods and services is expected to bring down inflation.
What are the risks of monetary tightening?
- Aggressive monetary tightening — like the one currently underway in the US — involves large increases in the interest rates in a relatively short period of time, and it runs the risk of creating a recession. This is called a hard-landing of the economy as against a soft landing (which essentially refers to monetary tightening not leading to a recession). The chances of a soft-landing for the US exist but are extremely low.
What is a recession?
- A recession is when the GDP growth rate of a country is negative for two consecutive quarters or more.
- Contracting GDP typically results in job losses, reduced incomes, and reduced consumption.
What is the likely impact on India?
- In the latest World Economic Outlook, the IMF has downgraded the growth projections for the US, China and India. “Downgrades for China and the United States, as well as for India, are driving the downward revisions to global growth during 2022–23. A global slowdown is unlikely to have any positives for India apart from some relief in crude oil prices.