FEDERAL FUNDS RATE

FEDERAL FUNDS RATE

WHY IN NEWS ?

• Recently, in concluded Federal Open Market Committee meeting on July 26, 2023, the targeted federal funds rate was raised to 5.25- ­5.5%, a 25 basis points increase.

MORE ABOUT THE NEWS:

• The hike in rates puts the rate at a 21­year high, surpassing the levels seen in 2001.
• Fed Reserve President Jerome Powell addressed the press conference and explained that the decision was aimed at reducing inflation to 2%.
• Despite the interest rate hike, he pointed out that employment numbers have been on the rise.

WHAT IS FEDERAL FUNDS RATE ?

• The term “federal funds rate” refers to the target interest rate range set by the Federal Open Market Committee (FOMC).
• The federal funds rate refers to the interest rate that banks charge other institutions for lending excess cash to them from their reserve balances on an overnight basis.
• The FOMC, which is the policymaking body of the Federal Reserve System, meets eight times a year to set the target federal funds rate, which is part of its monetary policy.
• This is used to help promote economic growth.

HOW ARE THEY DETERMINED ?

• It is customary for the Federal Open Market Committee to meet eight times annually to determine the federal funds rate.
• These rates are influenced by economic indicators, such as the core inflation rate and the durable goods orders report, which provide signals about the economic health of the country.

RECENT TRENDS IN RATES:

• The federal funds rate, currently set between 5.25% to 5.5%, plays a crucial role in the economy as it determines lending rates among banks.
• Following the global financial crisis, rates were near zero until 2015.
• However, with the pandemic, rates dropped to 0.05%.

• Since March 2022, there has been a steady increase in the rate, leading to concerns about the world economy’s ability to withstand such a sharp rise of more than 450 basis points within a year.
• The Federal Reserve intervenes in the market through bond purchases or sales to maintain the targeted rate range.

IMPACTS OF FEDERAL FUNDS RATE ON USA’S ECONOMY:

• The federal funds rate is one of the most important interest rates in the U.S. economy.
• That’s because it impacts monetary and financial conditions, which in turn have a bearing on critical aspects of the broader economy including employment, growth, and inflation.
• The rate also influences short-term interest rates, albeit indirectly, for everything from home and auto loans to credit cards, as lenders often set their rates based on the prime lending rate.
• The prime rate is the rate banks charge their most creditworthy borrowers—a rate that is also influenced by the federal funds rate.
• Investors keep a close watch on the federal funds rate. The stock market typically reacts very strongly to changes in the target rate.

IMPACT OF RATES HIKE ON THE WORLD:

• As interest rates in advanced countries rise, foreign investors may abandon government securities in developing economies, leading to currency depreciation and increased borrowing costs.

• This situation exacerbates debt servicing concerns for developing countries, where foreigners play a major role in the government securities market, unlike India.
• The large­scale expansion of the balance sheets of the advanced country central banks since the global financial crisis had reduced interest rates to abysmally low levels.
• This has facilitated carry trade, with agents borrowing in dollars and investing in emerging markets to benefit from interest margins due to the higher interest in developing countries.
• Between 2011 and 2016, external debt stocks in low and middle ­income countries doubled, reaching 181.1% of their GDP. By 2020, it exceeded 200% of their GDP.
• In the developing world, non­-financial corporations took advantage of low global interest rates to borrow cheaply.
• Approximately $5.14 trillion of the total outstanding dollar debt of $13 trillion held by non ­financial corporations outside the U.S. is from emerging markets and developing economies.
• With rising interest rates and currency depreciation, unhedged dollar debts could pose serious problems for these corporations.

WAY FORWARD:

• Massive scaling up of contingency financing for needy countries and expansion of affordable long term financing for development is required to address the growing concerns of developing country debt.

SYLLABUS: MAINS, GS-3, ECONOMY

SOURCE: THE HINDU