Explained: Fed Reserve rate hike, US recession and impact on India

In its ongoing effort to cool the raging inflation in the United States — at 9.1% in Juneinflation is at four decades high — the Federal Reserve or Fed (U.S. central bank) decided to increase the Federal Funds Rate target by an additional 75 basis points on Wednesday. Since March, the Fed has steadily pushed the target FFR from zero to nearly 2.5% now.

What is the Federal Funds Rate (FFR)?

The FFR is the rate at which commercial banks in the US borrow from each other overnight. The US Fed cannot directly specify the FFR, but tries to “target” interest rates by controlling the money supply. As such, when the Fed wants to raise prevailing interest rates in the U.S. economy, it reduces the money supply, forcing every lender in the economy to demand higher interest rates. The process begins with commercial banks charging higher rates to lend to each other for short-term loans.

Why is the Fed tightening the money supply?

This is called monetary tightening, and the Fed (or any other central bank) resorts to it when it wants to curb inflation in the economy. By decreasing the amount of money and raising its price (interest rates), the Fed hopes to dent overall demand in the economy. Reduced demand for goods and services is expected to lower inflation.

What are the risks of monetary tightening?

Aggressive monetary tightening – such as is currently underway in the US – means that interest rates are raised sharply in a relatively short period of time and there is a risk of a recession. This is referred to as a hard landing of the economy rather than a soft landing (essentially referring to monetary tightening that does not lead to a recession). The probability of a soft landing for the US exists, but is extremely low.

The most common definition of recession requires a country’s GDP to contract in two consecutive quarters. Shrinking GDP typically results in job losses, lower incomes and reduced consumption.

So, is the US in a recession?

A clear answer may be available as early as 6pm Indian time, when the US releases its second quarter (April, May and June) 2022 GDP growth data. Since US GDP has already contracted by 1.6% in the first quarter (January, February and March) of 2022, a contraction in the second quarter means the US is in recession (see Chart 1).

Federal Reserve, US inflation, US recession, India inflation, What is recession, US economy, US rate hike, Fed rate hike, India recession, Indian Express Chart 1: US real GDP

However, many observers also dispute this rather strict technical definition of recession.

Why do some people dispute that the US could be in a recession?

First, there’s a chance that US GDP won’t shrink. If that happens, the whole point is out of the question for now. We will know this Thursday at 6 pm (IST).

But there are other reasons.

A huge point of contradiction is the remarkable job creation in the first half of 2022. Despite the Fed’s aggressive monetary tightening, the labor market remains quite ‘tight’, ie unemployment is still at an all-time low. Despite a GDP contraction in the first quarter and a likely contraction in the second quarter, the US economy created about 2.7 million new jobs in the first half of 2022. years in the recent past.

This is why Fed Chair Jay Powell declined to characterize the US economy as one in recession when asked during Wednesday’s media interview. Janet Yellen, US Secretary of the Treasury (as well as former Fed chairman), has also argued that the US economy is not in recession, even as GDP shrinks for two consecutive quarters.

This leads to a broader issue of how one defines a recession.

In the US, it is the National Bureau of Economic Research (NBER) – more specifically the NBER’s Business Cycle Dating Committee – that usually declares a recession. But the NBER defines recession a little differently.

How does NBER define recession?

The NBER’s traditional definition of a recession is that “it is a significant decline in economic activity that is spread throughout the economy and lasts for more than a few months”. The committee believes that while each of the three criteria – depth, distribution and duration – must be met individually to some degree, extreme conditions revealed by one criterion may partially compensate for weaker indications of another criterion.

Why does the NBER not accept the two-quarters definition?

The NBER gives several reasons for this.

“First, we identify economic activity not only with real GDP, but we consider a range of indicators. Second, we look at the depth of the decline in economic activity… So real GDP could fall by relatively small amounts in two consecutive quarters without detecting a peak. Third, our main focus is on the monthly chronology, which requires consideration of monthly indicators. Fourth, by examining the behavior of manufacturing on a quarterly basis, where real GDP data is available, we give equal weight to real FDI,” according to the NBER website. The GDI refers to gross domestic income; this is also a measure of national income, albeit from the income side of the economy compared to GDP, which looks at the expenditure side of the economy.

According to NBER, the difference between GDP and FDI – called the “statistical discrepancy” – was especially important in the recessions of 2001 and 2007-2009.

How did GDP and FDI differ during the 2001 and 2007-09 recessions?

In 2001, for example, the recession did not take into account two consecutive quarters of decline in real GDP. However, the real GDI declined in the last three quarters of 2001.

In the latest recession, from its peak in December 2007 to its trough in June 2009, real GDP declined in the first, third and fourth quarters of 2008 and in the first and second quarters of 2009, while FDI fell for five years. fell. of the six quarters.

What is the outlook for the US economy?

The US economy is facing a curious situation. On the one hand, it has to do with an inflation rate of four decades, and on the other hand, with an unemployment rate of five decades (see Chart 2).

Federal Reserve, US inflation, US recession, India inflation, What is recession, US economy, US rate hike, Fed rate hike, India recession, Indian Express Chart 2: US unemployment versus recession

However, aggressive monetary tightening of the kind we are seeing now is likely to lead to a recession sooner rather than later.

The inflation rate in the US is over 9% and the Fed’s inflation target is 2% – that’s a 7 percentage point gap. Historically, every time the Fed attempted to cut inflation by more than 2 percentage points, the US has witnessed a recession.

The ongoing inversion of the bond yield curve is another robust predictor of a coming recession. On Wednesday, 2-year, 5-year and 10-year US bond yields were 2.97%, 2.83% and 2.78%, respectively.

In his statement on Wednesday, Powell made no bones about the Fed’s determination to bring inflation under control, even at the cost of economic growth and raising unemployment in the near term.

“We are very vigilant about inflation risks and are determined to take the necessary steps to bring inflation back to our longer-term target of 2 percent. This process is likely to be accompanied by a period of below-trend economic growth and some weakening labor market conditions, but such results are likely needed to restore price stability and pave the way for achieving maximum employment and stable prices over the longer term,” he claimed.

In other words, the Fed believes that the risks of doing too little (to contain inflation) are greater than the risks of doing too much (ie destroying demand).

What is the likely impact on India?

In the latest July update of the World Economic Outlook, the IMF lowered growth forecasts for the US, China and India. “Downgrades for China and the United States, as well as for India, are driving downward revisions to global growth in 2022-23, reflecting the materialization of downside risks highlighted in the April 2022 World Economic Outlook,” it said.

A global slowdown is unlikely to have any positive effects for India, other than some easing in crude oil prices.

The IMF has each knocked off nearly a full percentage point (to be precise 0.8%) of India’s GDP projections for the current year and the following year.

“For India, the review mainly reflects less favorable external conditions and faster policy tightening,” the IMF explains.

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