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Federal Funds Rate UPSC NOTE

 


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.

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Learnerz IAS | Concept oriented UPSC Classes in Malayalam: Federal Funds Rate UPSC NOTE
Federal Funds Rate UPSC NOTE
Learnerz IAS | Concept oriented UPSC Classes in Malayalam
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