What is the federal funds rate?
The federal funds rate, or Fed rate, is the interest rate that U.S. banks pay one another to borrow or loan money overnight.
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.
Recently in news
The targeted federal funds rate was raised to 5.25-5.5%, a 25 basis points increase.
This puts the rate at a 21-year high, surpassing the levels seen in 2001.
The decision was aimed at reducing inflation to 2%.
Despite the interest rate hike, the employment numbers have been on the rise.
What consequences would this have on the rest of the world?
The rest of the world faces a different situation compared to the green shoots of growth seen in the U.S. economy; they are yet to come out of the pandemic and are battling with growing debt servicing concerns.
The large-scale 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.
Will the rate hike impact corporates?
In the international economy, there has been a substantial increase in private non-guaranteed (PNG) debt taken by corporations, while governments continue to be important borrowers.
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 World Bank's recent debt report reveals that the poorest countries borrowing through the International Development Association (IDA) spend 10% of export earnings on servicing debt, the highest since 2000.
Climate goals are affected due to financial constraints.
Way forward
A collective effort is needed to reform the international financial system, addressing its asymmetries.
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.
COMMENTS