Image source: “Federal Reserve cuts interest rates, days after election of Trump” – NEWSThe US Federal Reserve cut interest rates by a quarter of a percentage point recently, setting borrowing costs just two days after the victory of President-Elect Donald Trump. Just a month ago, the US Federal Reserve (the Central Banking Authority in the US) slashed interest rates by a half point. The Federal Open Market Committee (FOMC) chose to lower its key borrowing rate by a half percentage point. It was the first interest rate cut since the early days of the Covid pandemic. The last time the FOMC cut by half a point was in 2008 during the global financial crisis.Now, let us know some of the basics.THE FEDERAL RESERVE SYSTEM OF U.S:The Federal Reserve System (in short, the “Fed” as called by the media) is America’s central bank (like the Reserve Bank of India in India). The Federal Reserve decides the Monetary Policy of the United States.The Chair of the Board of Governors of the Federal Reserve System is the head of the central banking system of the United States. The Chair is the “active executive officer” of the Board of Governors of the Federal Reserve System. “The current chair is Mr. Jerome H. Powell.’The Federal Open Market Committee – FOMC’ is the branch of the Federal Reserve Board that determines the direction of monetary policy. The term “monetary policy” refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. The Federal Reserve Act of 1913 gave the Federal Reserve responsibility for setting monetary policy. The term “monetary policy” refers to what the Federal Reserve, the nation’s central bank, does to influence the amount of money and credit in the U.S. economy.The Federal Reserve controls the three tools of monetary policy–open market operations, the discount rate, and reserve requirements. The Board of Governors of the Federal Reserve System is responsible for the discount rate and reserve requirements, and the Federal Open Market Committee is responsible for open market operations. Using the three tools, the Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and alters the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.While the rate sets short-term borrowing costs for banks, it spills over into multiple consumer products such as mortgages, auto loans, and credit cards. What happens to money and credit affects interest rates (the cost of credit) and the performance of the U.S. economy. Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.Present scenarioAt present, the decision was made despite most economic indicators looking good. The US GDP has been rising steadily. However, Mr.Powell and other policymakers have recently expressed concern about the labour market. While layoffs have shown little sign of rebounding, hiring has slowed significantly. How did this happen?COVID CrisisBetween mid-2021 and early 2022 US job openings doubled compared to unemployed workers (post-COVID). To attract employees, companies had to offer higher wages. And more money with the consumer meant more demand as it drove up the cost of goods and services all over again. Thus, the US inflation started going up. So, the Fed had to step in and increase the rates. When inflation surged, it stepped in and raised interest rates in 2022 and 2023, to cool things down. The logic is raising interest rates makes borrowing more expensive, so people and companies tend to spend less. This helps bring down inflation. But Higher rates also mean borrowing costs go up for companies, leading to cost-cutting, slower expansion, layoffs, and less hiring.US unemployment, which had been low, started going up. So, last year, the Fed decided to stop raising rates even further and kept them steady instead.But why should we bother if the US central bank cuts interest rates? The answer is that the US plays a huge role in the global economy, and central banks everywhere keep a close eye on its moves. So, the Fed’s actions, like interest rate cuts, can impact other economies. Lower US rates can make investing in countries like India more attractive. This strategy, known as carry trade, is where investors borrow money in the US (where rates are low) and invest it where rates are higher, making a profit on the difference. This could lead to more capital flowing into markets like India, leading to a boom in Indian stock markets.Past Lessons- 2008 Financial CrisisSince December 2008, the Fed has kept its benchmark interest rate at a range between zero and one-quarter percent. The move was announced in the backdrop of the longest recession, as jobs were being squeezed out of the economy, post-subprime crisis after the fall of Lehman Brothers Bank. The Federal Reserve acted in response to the financial crisis to help stabilize the U.S. economy and financial system. These actions included reducing the level of short-term interest rates to near zero. In addition, to reduce longer-term interest rates and thus provide further support for the U.S. economy, the Federal Reserve purchased large quantities of longer-term Treasury securities and longer-term securities issued or guaranteed by government-sponsored agencies. As discussed earlier, low interest rates help households and businesses finance new spending and help support the prices of many other assets, such as stocks and houses.Process: How the policy is implemented- (Quantitative (Monetary) Easing (QE))The most important step in QE is that the central bank creates new money for use in an economy. Quantitative easing as monetary policy is thus adopted by the government to increase the money supply in the economy to further increase lending by commercial banks and spending by consumers. The central bank infuses a pre-determined quantity of money into the economy by buying financial assets from commercial banks and private entities. This leads to an increase in banks’ reserves. With cheaper borrowing the hope is that the central bank will again encourage greater spending, putting additional demand into the economy and pulling it out of recession. As the money ends up in bank deposits, banks should also find their funding position improved and make them more willing to lend. One challenge is that this new money which creates excessive liquidity is expected to raise consumer prices giving people another incentive to buy now rather than later.Monetary Policy in IndiaRecently, the Reserve Bank of India’s (RBI) Monetary Policy Committee (MPC) kept the Repo rate unchanged at 6.5% for the tenth consecutive time in its October 2024 meeting. The MPC also changed its policy stance from “Withdrawal of Accommodation” to “Neutral.” This is despite US rate cuts, and recent data shows inflation control and robust GDP growth projections. This Neutral policy stance signals a readiness to act in either direction—if inflation remains under control and economic growth shows stability, the RBI may consider reducing rates shortly. On the other hand, if inflationary pressures rise, the bank may be forced to raise rates again. Currently, RBI has opted for a wait-and-watch strategy to assess how domestic and international factors play out in the coming months.According to some experts, the RBI decided to keep the policy rate unchanged on the back of potentially higher inflation, with higher food prices worldwide, and geopolitical conflicts. According to the RBI Governor, the Food component of retail inflation remains stubborn.The Repo rate, short for repurchase option rate, is the rate at which the RBI lends money to commercial banks and other financial institutions in India. When the repo rate is increased, borrowing from the central bank becomes more expensive for banks, which may then raise the interest rates for their customers. This can lead to reduced household spending as people have less disposable income. Conversely, a lower repo rate makes borrowing cheaper for banks, which can then lower their interest rates, encouraging consumer spending and boosting liquidity in the market.The Monetary Policy Committee (MPC) is a six-member committee that determines India’s monetary policy, including the policy interest rate. The MPC is made up of three Reserve Bank of India (RBI) officials and three external members appointed by the government of India. The RBI Governor is the ex officio chairperson, and the Deputy Governor in charge of monetary policy is also a member. The MPC meets at least four times a year and publishes its decisions after each meeting. The Monetary Policy Committee is responsible for fixing the benchmark interest rate in India.Government and the Central Bank:News: ‘Government and RBI disagree on interest rates.The Government of India does not seem to be on the same page as RBI regarding the need to cut interest rates amid concerns about slowing growth and inflation. The Finance Minister has said that if the Indian industry is to expand and build new capacities, “our bank interest rates will have to be far more affordable”. According to the Commerce Minister, the Central Bank should not factor in food inflation while deciding on lowering its policy interest rates, which have been unchanged since February 2023. The RBI, on the other hand, has termed the 6.2 percent year-on-year consumer price index inflation number for October — above its 6 percent upper tolerance limit — a “sticker shock” (Shock due to high or increased price). The current inflation, if allowed to run unchecked, “can undermine the prospects of the real economy.” The RBI’s latest ‘State of the Economy report ‘ has noted that it is not retail food inflation alone that is rising (from 5.4 percent in July to 10.9 percent in October), even “core” inflation, which excludes price increases in food and fuel, has gone up from 3.1 percent to 3.8 percent between June and October. The central bank’s concern is, that the increasing food prices can have an impact by transmitting to wages and spilling over into higher inflation. Such inflation, in turn, can hurt growth itself by biting into household consumption demand and corporate earnings, impacting their inducement to invest. Bringing down inflation closer to the RBI’s 4 per cent target, and anchoring the public’s inflation expectations, is hence desirable even from a growth perspective.The Central Bankers across the world have the tough task of managing the Interest Rate as they must ensure a balance between Growth and Price Stability.To quote” Stanley Fischer, Former Vice Chairman of the Fed.“Central bank communications can be a tricky business.”More By This Author:Economics For Everyone: 70 Hours Of Work – Labour Vs Leisure Economics For Everyone: 2023 Nobel Prize In Economics – Goldin’s Gender GapEconomics For Everyone- Gearing Up For G20
Economics For Everyone – Managing Through Monetary Policy – US And India
