How America’s Price War Is Hammering the World

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Why did the Fed raise the funds rate?

The federal funds rate is the interest rate at which banks lend money to other banks overnight. By raising this rate, the Fed is trying to push up short and medium-term rates in the economy. The idea is to make borrowing costly for both consumers and businesses. At higher interest rates, consumers are less likely to borrow and spend money. Moreover, with rising savings rates, consumers are likely to postpone their consumption. This helps curb demand and less money drives out goods and services; in the process, the rate of price increase or inflation decreases. US retail price inflation has been above 8% since March.

How do higher interest rates affect businesses?

At higher interest rates, borrowing becomes expensive. Businesses borrow less and invest less, creating fewer jobs. As a result, wages increase at a slower pace and overall retail price inflation declines. At least, that’s how it should work in theory. Rising interest rates have started to dampen consumer demand. Take the case of home sales. During the July-September period, the median selling price of homes sold in the United States increased by 10.6% per year. During the same period last year, prices had risen at a much faster rate of 21.8%. But a similar impact has not yet been observed with regard to wage inflation.

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What about wage inflation in the United States?

As Jerome Powell, the chairman of the US Fed, said: “The labor market remains extremely tight, with unemployment at a 50-year low…and wage growth strong.” to demand higher wages and companies are forced to pass on this higher cost to end consumers.

So what is the way forward for the Fed?

Some experts have argued that the Fed could over-tighten, that is, raise rates more than necessary. Powell doesn’t believe it, given that inflation remains high and the fed funds rate is still well below the rate of inflation. In this scenario, it is very likely that the Fed will continue to raise interest rates for longer than it initially expected. As the Fed Chairman said, “Reducing inflation will likely require a prolonged period of below-trend growth.”

What impact will this have on the world at large?

With rising interest rates in the United States, money is likely to move from other parts of the world to the United States. As money moves, the dollar will continue to appreciate against currencies such as the Indian rupee, Thai baht, euro and British pound, which will continue to lose value. This will make imports costly for these countries. In the process, as the United States attempts to control domestic inflation, it will continue to export inflation to other parts of the world.

Vivek Kaul is the author of Bad Money.

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