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Category: Current Economic News

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  • How does the Central bank control inflation?

    You may have heard in the news in the last year, that the Fed has been raising the interest rate. In this post, I will be explaining which is the “interest rate” and how the central bank of the U.S. (the Federal Reserve) does that to control inflation.

    After Jan 2022, there has been a steady rise in prices of many items, esp. fuel, housing rent, and food prices. If you want to understand what inflation is and how it is calculated, you can read my detailed article on inflation here.

    Inflation always happens when there is more demand than supply and when there is an expectation of inflation to continue. Producers raise the price of the goods and services in demand, to make more profit from them.

    The central bank of a country (the Federal Reserve in the US) intervenes when inflation is out of control or is significantly high compared to the target level. As this blog mostly focuses on the US Federal Reserve monetary tools, I use the terms the Fed and central bank interchangeably. However, central banks in other countries also use similar monetary tools.

    Is inflation always bad?

    In the US and many advanced countries, the target average rate of inflation is around 2% every year. This little bit of inflation rate is considered desirable, as it helps borrowers pay off their debt. When there is some inflation, borrowers will have to pay slightly less in purchasing power terms because their money is now worth less to the lenders, exactly by the rate of inflation.

    Additionally, it also motivates people to spend their money on goods and services instead of holding on to them, as their money will lose its value next year by the rate of inflation. So, we get our normal production and consumption, and the economy continues to run smoothly.

    What are the two goals of a central bank and how does it achieve it?

    The central bank uses monetary policy to keep inflation low and promote maximum employment. By maximum employment, we mean the highest level of employment that an economy can sustain while maintaining a stable inflation rate. In the US, these goals are referred to as the Fed’s dual mandate.

    You may ask how the Fed achieves its dual goals. Essentially, the Fed uses its monetary policy tools to start a chain reaction in the economy, each causing one another. In the US, the Fed’s chief body for monetary policymaking is called the Federal Open Market Commission (FOMC). FOMC meets eight times a year and looks at data on current economic conditions, like what is going up and what is going down and how the economy is likely to do in the future based on the data. Based on that information the FOMC makes monetary policy decisions.

    When inflation is high for a long period and unemployment is at a very low level, we call it an overheating economy. The central banks try to raise the interest rates to slow down the overheating economy. This is called contractionary or tight monetary policy.

    Tools of Monetary Policy

    Now, let’s look at the tools the Fed can use to bring inflation down to the stable 2% average rate. This is done in two steps:

    First, the Federal Open Market Committee (FOMC) will raise the target range for the Federal funds rate. This is the rate at which commercial banks borrow and lend their excess reserves to each other overnight. This rate is not set by the Fed, instead, it is determined by the market forces of demand and supply between commercial banks.

    On any given date, there are many different transactions in the federal funds market and they settle at slightly different rates, the effective federal funds rate measures the median rate of these transactions.

    FOMC sets a target range for the federal funds rate. In other words, the majority of the banks’ transactions should fall within the target range. Banks with deficits can borrow money from other commercial banks. The next day those banks return the money with a little bit of interest.

    Now, the main task for the Fed is to use its monetary tools so that this federal funds rate goes up because this is the driving force for all the other interest rates in an economy.

    Interest on reserve balance is the main tool

    So, to steer the federal funds rate in the target range set by FOMC, the Fed uses interest on reserve balance as its primary monetary policy tool. The interest on reserve balances rate is the interest received by commercial banks on deposits that banks hold in their reserve balance account at a regional Federal Reserve Bank. This interest rate is a risk-free investment option for commercial banks. This, the interest on reserve balances rate is set by the Fed and is, therefore, an “administered rate,”.

    Interest on reserve balance: Banks can deposit the excess reserve with the Fed risk-free overnight, and earn interest just like you can do with a savings account.

    When the Fed sees the economy is overheating with high inflation and a tight labor market, it tries to slow down the economy by raising the interest on the reserve balance. With that, the banks will be more willing to deposit their reserves with the Fed, rather than lending to other banks in the federal funds market.

    A key point to note here is that the interest on reserve balances rate serves as a reservation rate or the floor rate for banks. This is the minimum interest banks would be willing to accept in order to lend to each other, rather than keeping it with the Fed. If the Fed raises this interest on the reserve balance, commercial banks must raise the Federal funds rate in order to attract other banks to lend to them.

    Another key concept that ensures that the federal funds rate does not fall far below the interest on reserve balances rate is called arbitrage. Arbitrage means simultaneous purchase and sale of funds (or goods) in order to profit from a difference in price.

    So, for example, if we assume the federal funds rate is 1.75 percent and the interest on reserve balances rate is slightly higher at 2.25 percent, banks will see that they can borrow funds in the federal funds market at a lower rate and earn higher interest by depositing those funds at the Fed. They will keep doing that until with the forces of demand and supply, the increase in demand for funds in the federal funds market will cause the federal funds rate to rise. It will keep rising until it reaches the interest on reserve balances rate so that banks no longer see the opportunity to profit by borrowing in the federal funds market and depositing it with the Fed. 

    As the Fed sets the interest on reserve balances rate directly, the Fed can steer the federal funds rate up or down by raising or lowering the level of the interest on reserve balances rate. In fact, this phenomenon of arbitrage makes interest on reserve balances a very effective tool for steering the federal funds rate direction.

    There are two other tools that the Fed can use to guide the federal funds rate

    1. By setting a floor with an overnight reverse repurchase rate,

    2. and by setting the ceiling using a discount window

    Let’s understand both of them.

    The Fed has an overnight reverse repurchase facility that is open to a broader set of financial institutions, as interest on reserve balances is available only to banks and a few other institutions. This facility allows these financial institutions to deposit their funds at a Federal Reserve Bank and earn the overnight reverse repurchase agreement rate offered by the Fed.

    Thus, the overnight reverse repurchase agreement rate does the same thing as the interest on reserve balances rate does by acting as a reservation rate for these financial institutions. If this rate is higher than the federal funds rate, then by pressure of demand and supply, the Federal funds rate starts going up until there is no profit from arbitrage. The overnight reverse repurchase agreement facility is a supplementary tool because the rate the Fed sets for it helps set a floor for the federal funds rate.

    So when it raises the overnight reverse repurchase rate, the Federal funds rate tends to move up as well.

    The discount rate is the rate banks have to pay to the Fed for borrowing money from the Fed through the Fed’s discount window. Banks are more likely to borrow from each other (at the federal funds rate) only if it is lower or equal to the discount rate that they have to pay to borrow from the Fed. Thus, the discount rate acts as a ceiling for the federal funds rate. Also, it is set higher than the interest on reserve balances rate and the overnight reverse repurchase agreement rate.

    Lastly, there is another tool that used to be the Fed’s primary tool to control the money supply in the economy before the 2008 financial crisis. This is called open market operations where the Fed would buy or sell t-bonds. Now, with ample reserves in the banking system, the Fed only uses this as a supplemental tool to help maintain ample levels of reserves. The Fed can buy or sell government securities in the open market to increase or decrease these reserves in the banks account with the Fed.

    In a nutshell, when the Fed wants to control inflation, it would set a higher range for the Federal funds rate. To achieve this target, it would increase the interest on reserve balances rate as the main monetary policy tool. It can also use additional tools by raising overnight reverse repurchase agreement rate, and discount rate. All this will ensure the federal funds rate stays within the high target range set by the FOMC.

    Why does the Federal fund rate matter?

    Since the federal funds rate affects all the other interest rates in the economy, all the other interest rates go up as well. At high interest rates, households will borrow less money to buy big-ticket items they want. This will cause a reduction in spending by households. This will cause overall savings to increase because now they are getting higher interest rate to save money in a bank.

    Once household demand is reduced, firms will reduce their investments. They will also reduce their workforce and demand fewer workers. This will reduce employment levels also and cause the inflated prices to return to the target of 2%.

    The now-raised federal fund rate would cause other market interest rates like mortgage, auto, and other interest rates that banks charge from households and businesses to rise as well. The increased cost of borrowing will reduce spending across all sectors of the economy, lowering excess demand and bringing prices back to normal.

    The Fed will do the exact reverse of this process when the economy is in a recession when the inflation is below the 2% target rate and there is high unemployment. It will lower the Federal funds rate target range by lowering interest on the reserve balance. It can also use additional help from lowering interest on overnight reverse repurchase agreement rates, and discount rates to give a boost to the economy.

    How effective are these tools in reality?

    All these monetary policy tools only work when inflation is caused by demand-pull factors. However, if it is due to cost-push factors, this measure may cause more harm than good. Cost-push factors include supply shocks when the supply of the products is hampered. There could be many reasons for a reduction in supply such as increased cost of raw material and other inputs, and natural calamities. Trade restrictions such as sanctions imposed on a country can also cause supply disruptions.

    Also, there is a direct link between reducing inflation and reducing overall economic growth. Even though central banks aim for a soft landing when they raise interest rates to bring down inflation, sometimes it doesn’t go as planned.

    In economics, a soft landing means a moderate economic slowdown following a period of growth. In the past, the Fed in the US has had a mixed record in achieving a soft landing when it raised interest rates.

    In addition, inflation expectations continue to play a key role in how people react to the contractionary monetary policy. If people continue to believe the prices to go up, they will tend to make the purchases now, rather than in the future when the worth of their money can get further low.

    The board of governors at the Fed, as well as various economists that work there, take into consideration all these factors and keep a watch on the trend. They can alter the monetary policy according to the direction of its performance.

  • Top 6 economic trends

    In this post, we will discuss the top 6 economic trends that will become more popular in the year 2024.

    1. The rise of artificial intelligence and automation in various industries, such as manufacturing and transportation. For instance, self-driving cars will become more prominent, which may reduce the need for human drivers.

    2. The continued growth of e-commerce and online retail, with companies like Amazon expanding their reach and dominance. As people increasingly prefer shopping from the comfort of their homes, traditional brick-and-mortar stores may face challenges.

    3. The increasing importance of sustainability and environmentally-friendly practices in business operations. Companies that adopt sustainable measures and invest in renewable energy may gain a competitive edge.

    4. The rise of the gig economy and freelance work, as more people choose flexible jobs and remote work options. Platforms like Fiverr and Upwork will continue to thrive, connecting freelancers with work opportunities.

    5. The impact of demographic changes, such as an aging population and changing consumer preferences. Industries catering to healthcare, elderly care, and wellness will experience significant growth.

    6. Let’s not forget about cryptocurrency and blockchain technology’s impact on the financial sector. These technologies have the potential to revolutionize the way we handle transactions and secure data.

    Conclusion

    To sum it up, the top 6 economic trends in 2024 are the rise of AI and automation, the gig economy, sustainability, e-commerce growth, and cryptocurrency’s influence.

    These are just a few examples of the economic trends we expect to see in 2024. It is essential for individuals and businesses to adapt and stay informed about these changes to thrive in the future.

  • The rice export ban by India will have a major impact on the World

    Hi all, today, I am going to dive into some breaking news that’s sending ripples across the world’s food markets.

    There’s a rice ban in play by the Indian government, and it’s set to have some major consequences.

    Brace yourselves because this ban is no small deal. It’s projected to reduce the world’s rice shipments by almost half, leaving many wondering what this means for inflation and food prices worldwide.

    What is causing the ban?

    So, you might be asking, “Why the ban in the first place?” Well, here’s the deal –

    Last week, the Indian government put a ban on the export of non-Basmati rice varieties.

    Retail prices for white rice have been on the rise in India, and it’s got the Indian government on high alert.

    In just one month, white rice prices shot up by 3%; over the past year, they increased by a whopping 11.5%. Ouch!

    But here’s the kicker: Devastating monsoons, on which Indian agriculture relies heavily, are the main reason affecting this price surge.

    The unpredictable weather has wreaked havoc on rice production in India, creating concerns about food supplies in India and beyond.

    And that’s why the Indian government had to make some tough decisions.

    Key points showing the impact

    Now Let’s break down some key points to get a clearer picture of the impact:

    1. A rice ban of this magnitude will affect about half of the world’s rice exports – that’s a huge chunk!
    1. India is a major player in the global rice market, accounting for a whopping 40% of all rice exports. So, when India makes a move, the world will notice.
    1. Here’s a staggering statistic: rice is a staple food for over 3 billion people worldwide. Yes, you heard that right, 3 billion! That’s roughly 40% of the entire world’s population relying on rice as a dietary staple.

    NRI community in the US is hoarding rice further increasing the price and shortage

    In the US, the ban on non-Basmati rice exports from India is causing quite a stir. This is especially among the Telugu community living here. People are rushing to stock up on rice, fearing a potential shortage and higher prices.

    Indian grocery stores in major cities like Texas, LA, Michigan, and New Jersey are seeing long queues and a surge in demand for rice.

    Why all the fuss over rice? Well, a 9kg bag of rice is being sold at a massive PRICE OF 27 dollars due to the export ban, which is contributing to the worries.

    These grocery stores have even implemented restrictions, allowing only one rice bag per customer to manage the situation.

    Why is this panic buying happening?

    The panic buying might be twofold:

    First, there’s concern about the scarcity of fine variety rice like Sona Mahsuri, which is much sought-after.

    And secondly, with the ban in place, there’s a possibility of rice prices skyrocketing.

    According to a leading economic news source in India, Economictimes, several countries, including Benin, Nepal, Bangladesh, China, Cote D’Ivoire, and others, heavily rely on non-basmati rice imports from India. With this recent ban, it’s projected that world rice shipments will be cut almost in half, raising fears of global inflation in food markets.

    So, guys, this rice ban is causing quite a stir in the world’s food markets  With half of the world’s rice shipments set to be impacted and India being a significant player in the global rice trade, we can’t underestimate the potential consequences.

  • Why did SVB collapse?

    So, there’s been some big news in the banking world. First, Silicon Valley Bank, which had a lot of high-profile tech investors as clients, collapsed on Friday. Federal regulators have taken over the bank since then. It’s actually the largest U.S. bank to fail since the 2008 financial crisis. Then, on Sunday, regulators started worrying about New York’s Signature Bank. This bank had a lot of money tied up in the unpredictable cryptocurrency market.

    Both Silicon Valley Bank and Signature Bank are under the Federal Deposit Insurance Corporation (FDIC) control. This happened after Silicon Valley Bank experienced a run on the bank last week, with people withdrawing billions of dollars in deposits.

    men with finance business report and money vector illustration

    The different business model of this bank

    Do you know how Silicon Valley Bank wasn’t really a name you’d hear outside of Silicon Valley and the tech industry? Well, that’s because their clients were mainly venture capital firms, startups, and wealthy tech employees. They were in the game for around forty years and even managed to compete with big financial institutions. But in the end, SVB collapsed in just a few days.

    Apparently, around 90% of SVB’s accounts had over $250,000 in deposits, which is higher than most banks. This means most of their deposits weren’t backed by government insurance, according to a report. Also, experts pointed out that SVB’s business model was more like a local bank from the 1800s or 1900s, focusing on deposits and local customers, while bigger banks had more diverse funding sources and customers.

    In 2020, SVB’s deposits surged, but unfortunately, they invested those extra billions in long-term Treasury bonds just as the Federal Reserve raised interest rates. This led to a decline in the value of government bonds, and more depositors withdrew their money. Last week, SVB announced a loss of $1.8 billion from selling some of its bond holdings, leading to a run on the bank. Federal regulators ended up taking control of the bank last Friday.

  • The latest inflation report is out! What to expect next from the Fed?

    The bureau of labor statistics (BLS) just released the inflation number for January 2023 for the United States.

    There is a 0.5% increase from the December number, and inflation sits at still a whooping high of 6.4% over the last 12 months from January 2022.

    As you can see in the BLS chart above, the year-to-year inflation is 6.4% for all the items, 10.1% for food, 8.7% for energy, and 5.6% for all the things except food and energy. Also, in their press release, they mentioned the index for shelter was the largest contributor to the monthly inflation number.

    By shelter, they mean rents and owner equivalent rent cost of housing.

    If you look at this detailed table from them, it shows the breakdown in prices for all the individual items.

    Source: BLS


    Under the energy category, fuel oil is still up by 27.7% for the 12 months. Natural gas is also up by 26.7% in the 12 months.

    There is a 14% rise in Dairy and related products in the food category. 

    You can see that the highest inflation happened in cereal and bakery products. This was mainly because of the rise in egg prices because we felt that in the grocery stores.

    What caused egg prices to rise so much?

    Economists think the bird flu was the main reason behind increased egg prices because about 40 million egg-laying hens died in 2022 because of this disease.

     At the same time and the demand for eggs continues to rise because it provides a cheaper source of protein to many Americans. Thus both these supply and demand factors contributed to a significant rise in egg prices. 

    Was this inflation expected?

    This came as a little bit of a disappointment because people were expecting the overall inflation not to rise if not fall from the December level, even though fuel prices seem to be falling.


    Inflation is still high on many essential things, and it continues to be the biggest hit to poor Americans. It acts like an indirect tax on them.

     
    Unfortunately, most of this inflation we are experiencing is caused by supply-side factors, which are difficult to fix in the short run.

    Policy implication

    The government can only focus on controlling the demand aspect of inflation in the short run. As a result, the Fed will continue to tighten the monetary policy and raise interest rates until inflation reaches around 2%

    The federal reserve has been trying to control inflation using interest rate hikes to slow the demand in the economy.


    To learn more about inflation, how it is calculated, and the factors that cause it, please see my post here.

  • How does people’s expectation about inflation affect the actual inflation?

    What people like you and me think about inflation directly impacts the actual inflation rate. So, if we think inflation will be high in the coming months, it will most likely be. In this post, I will explain how this phenomenon works.

    If we expect that overall prices are going to rise in the coming months, we may buy more things now, rather than in the future. If a lot of people do that, this increases the demand for goods and services.

    High inflation is directly linked to a higher demand that is not immediately matched by an increase in supply. As a result, firms increase the prices of goods and services when there is more demand. This enables them to make more profit. As a result, we see increased prices passed on to the consumers causing higher inflation.

    On the other hand, if people expect prices to fall in the future, they may delay spending now to get a better deal. This will result in a decrease in demand for goods and services and businesses will end up lowering prices to clear up their stock.

    So, now we understand how inflation expectations affect actual inflation. If you want to know more about inflation and how it is calculated, you can refer to my post here.

    What is the current inflation expectation in the U.S.?

    After suffering from really high inflation close to 8%-9% for over half a year, we foresee some good news. A survey conducted by the Fed reserve bank of New York shows a decrease in these expectations.

    People in the U.S. feel that one and three-year-ahead inflation are now going to be 5.7 % and 2.8 % respectively.

    These are clearly lower than 6.2 % and 3.2 % in June for one and three years ahead inflation rates respectively. In the figure from the Federal Reserve of New York website, you can see how there is a decline in the curve of the expected inflation rate towards the end. This is the survey done in the month of August 2022 about what people think inflation may look like for 1 year and 3 years.

    It shows that people’s expectations are consistent with what the Fed is trying to achieve. By raising interest rates, the Fed is trying to slow down the demand in the U.S. When borrowing becomes expensive, people generally tend to borrow less for things like cars, mortgages, etc.

    In their September 20 meeting, the Fed is most likely going to raise the key federal funds rate by another 75 basis points. The Fed has been raising interest rates to fight the high inflation in the U.S for the last 6 months. Central banks in a lot of other countries fighting inflation have been doing the same.

    To learn more about the role of the central bank, stay tuned for my next post.

  • Did inflation fall to 0% in the US in July?

    Yesterday, in the news, I read President Biden saying the US had 0% inflation in July. The BLS, the official source of inflation numbers, reported no change in the CPI (Consumer price index) from June.

    So did inflation suddenly disappear? Well, it depends on how you measure it.

    Sometimes, the way politicians report some facts could give us misleading conclusions. So, the economist in me had to write something today to help my readers understand it better.

    How do we measure inflation?

    As I said above, the official inflation number in the US comes from the BLS every month. BLS calculates price inflation both monthly and annual.

    If you want to know more about inflation in simple words, you can read my previous posts. I described how we can calculate inflation using some simple examples. I also explained what policy measures the central bank takes to control inflation – my most favorite post.

    So was Biden lying when he said 0% inflation?

    There was indeed no general average price increase from June 2022 compared to July 2022. This meant a 0% monthly inflation.

    However, the year-to-year inflation ending July 2022, was 8.5%. This is still very high, compared to the average US inflation of around 2%. Inflation is the percentage price increase of a basket of goods and services people in the urban United States use. This is of course, over a specific period.

    But, the good news is that it was somewhat less than the June 2022-to-2021 inflation of 9.1%.

    A picture is worth a thousand words

    Here is a chart showing category-wise inflation. The food prices continued to rise. Few others, such as electricity, new vehicles, and shelter also rose.

    The main reason behind 0% monthly inflation was the falling gas prices. It offset the increase in food and shelter indexes. The lower gas prices finally come as a relief to millions of Americans. We have been experiencing a sharp rise in gas prices for a long time and wanted a break.

    Hopefully, Fed’s tight monetary policy will bring inflation down further in the coming months. But, there might be a cost to it- the possibility of a recession. As we say in economics, there is no free lunch. Let’s just hope that even if the R word happens, it is not significant.

  • The jobs market in the US is still going strong

    Two days ago, President Joe Biden proudly posted that the unemployment rate in the US was 3.5% in July. This matched the lowest rate in the last 50 years. He also said that since he started, 10 million jobs have been created in the US economy.

    Praising the fastest-growing job market, Biden mentioned that 528,000 jobs were added in the US in July itself. “Today, we also matched the lowest unemployment rate in America in the last 50 years: 3.5%,” he said.

    The Bureau of Labor Statistics (BLS) in the US publishes data for the unemployment and labor force statistics every month. These are based on the data collected from household surveys and establishment surveys on sample-based estimates of employment.

    I got this Civilian unemployment rate graph from the BLS. You can see that the US unemployment rate is now at its lowest level at 3.5%. This had happened three times before in Sep 2019, Jan 2020, and Feb 2020, when it hit 3.5%.

    But have you ever wondered what is the unemployment rate anyway?

    Well, the unemployment rate is the percentage of people who don’t have a job but can work and have actively looked for a job in the past 4 weeks. This is relative to people in the labor force.

    According to the BLS, The labor force is the sum of employed and unemployed people ages 16 and older at a given period.

    Their recent report about July’s unemployment rate was contrary to what many people would have expected. People were expecting a somewhat slowdown in the job market, but clearly, this hasn’t happened yet. The Fed has been raising interest rates to control inflation. The Fed’s policy aims to cool the overheated economy by reducing overall spending by individuals and businesses.

    So what does a low unemployment rate mean for you?

    If you are looking for work or want a change of job, right now could still be a good time for that. There’s a huge likelihood of you finding it sooner than later and as per your terms. With many employers paying higher salaries, it is a good time to ask for a raise if you think you deserve it.

    When the effects of tightening monetary policy start showing up and we see a reduction in jobs created, it might be a little late to negotiate.

    As always, if you enjoyed reading my post and learned something, please feel free to write your views in the comment section below. Thank you, till we meet again next time!

  • IMF predicts further slowdown for the world economies

    The International Monetary Fund in its latest World Economic Outlook report, published on July 26, 2022, has lowered its estimate of Economic growth for the world economies. This is a downward revision from their April 2022 projections of GDP growth rate for both 2022 and 2023. Below is the chart I took from the IMF website showing their growth projections by region.

    I have tried to summarize the main points of the report for you. If you are interested in reading the full report, please click here. https://www.imf.org/en/Publications/WEO/Issues/2022/07/26/world-economic-outlook-update-july-2022

    Lower GDP growth but higher inflation globally in 2022-23

    The GDP of the World is now expected to grow at 3.2% this year and 2.9% next year, compared to what they had predicted in April to be 3.6% in both 2022 and 2023.  While they predicted lower GDP growth across the globe, they raised their inflation estimates. The report predicts a 6.6% inflation in advanced economies and 9.5% in emerging and developing economies.

    What are the main factors behind this?

    The report cited various reasons for its downgrade revision. On top of the pandemic after effects, higher-than-expected inflation has been a major cause of worry worldwide, especially in the US and major European countries. This has caused the central banks of these countries to raise interest rates, making financial conditions tighter.

    Additionally, China’s economic slowdown has been worse-than-expected due to its zero covid policy. This has caused longer lockdowns, affecting their exports to the major US and European economies, and causing supply chain issues. This has also led to a supply-induced inflation.

    The report fears that given the current scenario, the Russian – Ukraine war could continue for long and sanctions associated with it could go up further. This will, unfortunately, cause more problems in energy and food markets’ supply.

    They also ran an alternative scenario of a possibility of a full shutdown of Russian gas flows to Europe by the end of 2022. If that happens, GDP global growth might fall further to 2% next year. The report also stated that since 1970, global growth has only been lower five times, so this does look very gloomy.

    What should the countries do to overcome this?


    The report suggests that controlling elevated inflation should remain the priority of policymakers around the world. This requires tightening monetary policy, and many central banks have started to do that already, both in advanced economies and emerging markets.

    They also noted the role of Fiscal policy is important here to protect the vulnerable population. But it is important that the fiscal policy (like in the form of subsidy or stimulus payments) should only target the weaker population and should not interfere with the overall disinflationary motive of monetary policy. Because a lot of inflation in the advanced economies was caused by this issue, where too much money was chasing too few goods. In other words, people got the money to spend, but not that many goods and services were getting made, causing excess demand and inflation.

    The report concluded that policymakers must continue to work on increasing vaccination rates to protect against future outbreaks. Lastly, countries must collaborate to address climate change and speed up the green transition to avoid their dependence on oil.

    Please let me know in the comment section your feedback on what topics you would like me to write about.

  • Why did Fed raise interest rates again, making borrowing more expensive?

    Ending their two-day meeting, the Fed (central bank of the US) has once again raised interest rates. The reason for the hike is to control inflation. The United States Congress has given the Fed a dual responsibility – to achieve maximum employment and keep inflation around the rate of 2% over the longer run.

    The average consumer in the US has been feeling the burden of rising prices, especially since the start of this year, esp. in gas, housing (including rental), and food prices. The Consumer Price Index, which measures inflation in the US has been at an elevated level for quite some time. In their press release, as of July 13, 2022, the BLS published inflation at 9.1%.

    How does the interest rate affect inflation?

    Going back to today’s news, let’s understand how the interest rate mechanism works. The FOMC (Federal open markets committee) is responsible for determining the federal funds rate target range. This is the rate at which banks borrow from each other. The Fed doesn’t set this rate, but market forces determine it.

    The reason this rate is very important to us is through its linkages to other rates. This federal funds rate impacts all the other interest rates such as on credit cards, housing, auto, and education loans.

    How much did Fed raise interest rates?

    In today’s meeting, the Federal open market committee decided to raise the target range for the federal funds rate from 2.25% to 2.5%. This increase has moved the Federal funds rate to its highest level since December 2018. During their June 13, 2022 meeting, they increased the target range for the Federal funds rate to be 1.25% – 1.75%. You can see the graph of this rate over time here.

    So how does the Fed steer the federal funds rate?

    It uses “interest on reserves balance” as its main monetary policy tool for that. To understand it better, you can read my article here, which explains this in detail. When the Federal funds rate (borrowing costs of banks) is high, banks will pass on these added costs to their final consumers. These consumers include people like you and me, and businesses.

    In a nutshell

    The main idea behind this repeated increase in the interest rate is that expensive loans will discourage people from spending. When the cost of borrowing (interest rate) is high, general consumers (households) borrow less for a big purchase such as a car or a house. Similarly, businesses also invest less in the expansion of their plant, inventories, machinery, buildings, etc. All of this will reduce the demand for goods and services these businesses make and they will also hire fewer workers. And when the excess (increased) demand is lower, the prices will eventually start falling, which will control high inflation. Thus, interest rate hikes are the Fed’s main tool to control inflation.

    Inflation happens because of strong consumer demand, which supply can’t match. Supply bottlenecks with China during the Covid pandemic, Ukraine war, etc have all contributed to a weaker supply of many essential items we use every day. Since many of the supply chain issues will take a long time to fix, the Fed is trying to control the demand aspect of inflation. By raising interest rates, and making borrowing more expensive, the Fed is hoping to weaken Americans’ willingness to spend money and ultimately bring inflation close to its 2% target level.