Fed Does It Again As Uncertainty Persists!

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Recently, the Federal Reserve Bank raised its interest rates by 0.75 percentage points. This has pushed up the benchmark overnight borrowing rate to the rage of 2.25 – 2.50 percent. In fact, the possibility of a consecutive increase in the interest rates was considered as imperative in the policy document of June 2022 itself, due to many factors such as the elevated consumer price index (CPI), tightened monetary conditions and increased volatility in rates, which heightened the uncertainty about the economic and monetary policy outlook.

These factors have continued to dominate the monetary policy outlook in this month of July too. Besides the downside risks to the US economy were also noticed in the wake of the potential for shocks from the rest of the world reflected through upside surprises to inflation. Moreover, respondents to the Open Market Desk’s surveys of primary dealers and market participants indicated possibility of deceleration in the growth rates of the US economy in the financial year 2022 and 2023. Further, even as they perceived a possibility of substantial decline in inflation in the year 2023, yet considering a wide range of potential scenarios, there was also a possibility that inflation may continue to be at elevated rates as well.

Taming inflation continues to be the top priority

The main reason of bringing about consecutive increase in interest rates is rampant increase in inflation. Fed has only reaffirmed that taming inflation continues to be its top concern even if it means slowing the economy for a while. However, promoting maximum employment and maintaining price stability too are other goals that fed is mandated to pursue. And so an indication has also been given that if the policy instance is seen as impacting inflation, Fed may as well not continue the spree.

How Fed interest rate hikes affect Borrowers

Any increase in the borrowing cost adversely affects the consumers as well as the producers and quite often it acts like a double-edged sword that hurts either way. If the producers pass on the burden of increase in costs on to the consumers, it further adds to the inflationary pressures. Consumer demand may dampen due to increase in prices on one hand and increase in EMIs on the other hand. This year fed has increased interest rate four times yet inflation still reached upto record level of 9.1 per cent in June 2022.

An example could be the impact on home sales in the US in the recent times. Home sales fell 5.4 per cent in June 2022 compared to May 2022 as per the data shared by the National Association of Realtors. As compared to June 2021, home sales were even lower by 14.2 per cent. The main reason was continued increase in home prices by 13.4 percent on one hand and an increase in the mortgage rates from an average of 2.88 per cent about a year ago to 5.51 per cent in July 2022, on the other hand. What surprises more is the fact that the home sales are decelerating even as there is increase in the number of properties for sale by 9.6 per cent when compared to May 2022 and 2.4 per cent when compared to June 2021.

Expectations of successive increase in interest rates act like fuel in the fire.

Mortgage rates are increasing in consonance with a sharp increase in 10-year Treasury Yields which is not only being affected by increase in the Fed benchmark rates but also an expectation that they may keep rising in the coming months also. In July 2022 Desk Survey for instance, most respondents expected a 50-basis point increase in the policy rates in September to follow. They also expect the federal funds rate to remain above the Survey’s long run policy rate of 2.4 percent through the end of the year 2024 though they placed significant probabilities on lower rate outcomes.

The global cues are projecting no different scenario as the central banks of eight advanced economies have raised their policy rates this year which is indicative of a policy tightening regime already in vogue with an expectation that the policy rates would reach peak levels in the year 2023.

At the domestic level, the US economic activity is projected to be weaker than June forecast reflecting reduced momentum in the economy and current and prospective financial conditions may be less favorable to support the aggregate demand. Total price index for personal consumption expenditures (PCE) is expected to be 4.8 percent in 2022 and core inflation is expected to be 4.0 percent. Besides, Fed is expecting the Core PCE inflation to come down to 2.6 percent in the year 2023 and further to 2.0 percent in the year 2024 hoping that the supply chain imbalances would be eased out in the months to come may be due to a possible resolution of issues which have cropped up on account of the geo-political tensions persisting over a period of time. Another ray of hope is enticed because even as the US real gross domestic product (GDP) has reportedly declined in the first half of the year, yet, labour demand remained strong amidst elevated consumer price index.

Resolution of Geo-political Issues is a cherished hope

Geo-political tensions between Russia and Ukraine culminating into War have caused great deal of human and economic hardships to the rest of the World. This is imperative as we are living in a value chain driven globalized world. And so any disturbance in any part of this world is bound to affect the other countries directly or indirectly involved in it either ideologically or economically. In the current scenario it is observed that the continued war between the two nations is creating additional upward pressures on inflation and the resultant downward pressures on the global economic activity. Therefore the monetary policy has to take cognizance of the inflation risks that are likely to persist as the resolution of the geo-political issues continues to be at the most a cherished hope for now.

Domestic forces also caused a consecutive rate hike

Current economic activity in the US is impacted by deceleration in the consumer expenditure, housing activity, business investment and manufacturing production compared to corresponding period in the year 2021. One of the main reason of softening of the aggregate demand could be tightening of the financial conditions due to unwinding of the large scale support to the consumer spending extended under the pandemic related fiscal measures, reduction in disposable incomes of the consumers on account of rampant rise in inflation and other factors such as stronger dollar causing weakening of external demand.

Now the question arises that if there are downside risks already observed in the economy, why Fed has gone for a consecutive rise in the interest rates? Well, despite all odds, there are some cues such as strong labor market, low unemployment rates and a strong possibility of full resolution of supply difficulties. Therefore, a moderate growth rate expected in the second half of the year may actually help in taming inflation to it normal course. Besides, though the financial market liquidity was low, yet the markets looked like functioning in normal ways. Thus, Fed has decided to go for a consecutive hike in interest rate as achieving price stability is its primary objective, yet it has discussed the positives also present in the economy and so we may hope that there may not be another consecutive increase in the interest rates or of similar magnitude in the next policy instance to be taken by Fed.