Friday, December 18, 2015

[Editorial # 17] Fed's liftoff ends uncertainty: The Hindu

The U.S. Federal Reserve’s decision to finally start normalising interest rates, by raising the fed funds rate by one quarter of a percentage point, has emphatically ended the uncertainty over the direction the world’s largest economy is headed in. Seven years after the Fed embarked on its record monetary expansion — by beginning a programme of bond purchases and cutting itsbenchmark rate to near zero — to provide a stimulus in the wake of the 2008 financial crisis, the U.S. central bank has signalled that the American economy has definitely turned the corner. Fed chair Janet Yellen’s categorical assertion that the decision “reflects our confidence in the U.S. economy” and that the Federal Open Market Committee (FOMC) sees the economy on a path of sustainable improvement, should give comfort to investors worldwide that a key engine of the global economy is now ticking. Simultaneously, the Fed held forth the reassurance that its stance remains accommodative to support the recovery and help return inflation to the targeted level of 2 per cent. The widely anticipated decision should now infuse some much-needed optimism across both developed and emerging markets, especially at a time when global trade is stagnant and commodity prices continue to remain depressed as demand from China’s slowing economy stays muted. If history is any guide, previous tightening cycles from the Fed both in 1999 and in 2004 were coterminous with increased capital flows into emerging markets as economic growth in the U.S. spurred demand for goods and services in the developing and exporting nations. But conditions, as some economists point out, are different this time, with the majority of emerging market currencies more expensive than they were 11 years ago on an inflation-adjusted, trade-weighted basis. The immediate reaction in India’s markets was positive on Thursday as both stocks and the rupee ended stronger. And with adequate foreign exchange reserves accumulated as a bulwark against any sudden, sharp capital outflows, the Reserve Bank of India and Governor Raghuram Rajan — who had been calling for a gradual end to global easy money — appear well-prepared to deal with any exigencies, should they arise.

That the road ahead could still be anything but smooth and straight for both the global economy and the emerging markets is also amply evident in the language contained in the Fed’s communication. The FOMC statement made it clear that “economic conditions will evolve in a manner that will warrant only gradual increases” in the benchmark rate. This is shorthand for saying that interest rates are likely to inch up and over a longer duration rather than mount a well-spaced and clearly graded timetable of staircase steps. With China’s surprise yuan devaluation of August and the resultant turmoil still fresh in memory, Chinese policymakers, along with the monetary authorities in Japan, the United Kingdom and the European Union, would be closely tracked. For Indian companies, new overseas loans are likely to start getting costlier, and the appreciation of the dollar could roil corporate balance sheets as debt-servicing gets more expensive.


1 What is meant by fed fund rates?
2. Why is this in the news?
3. What is the 2008 Economic Crisis?
4. How is 2008 economic crisis linked to fed fund rates?
5. Why has the fund rate been increased?
6. Is this increase going to impact India? If yes then how?
7. The article talks about an inflation rate of 2%. What do you understand by this?
8. What is the current inflation rate prevailing in India?
9. How is inflation measured in India?
10. Which agency is responsible for determining inflation rates in India? What are various indices to measure inflation?


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  2. The federal funds rate in the United States refers to the interest rates charged by depository institutions such as banks and other credit organizations on the loans given to other depository institutions on an overnight basis, and which is in addition UN-collateralized. This fed reserve rate represents the call rate of the Indian call money market, which comprises of lending and borrowing of un-collateralized funds over a time period of one to 14 days. This federal funds rate refers to the interest charged on loans given from the reserve account. The reserve account refers to the proportion of funds that banks maintain in the accounts of the Federal Reserve . This is similar to the Cash Reserve Ratio (CRR) in the Indian economy on which banks do not earn any interest. The Federal funds rate is negotiated between the borrowing bank and the lending bank and the weighted average value of the interest rates on all such transactions are calculated and this forms the federal funds effective rate. The federal funds target rate is arrived at during negotiations within the Federal Open Market Committee (FOMC) which meets every seven weeks or more if necessary.

  3. 8. Current inflation rate in India is 5.75% which has fallen down by 1% since the last year
    9. Inflation in India is measured based on certain indices.Broadly, there are two categories of indices for measuring inflation i.e. Wholesale Prices and Consumer Price.There are certain sub-categories for these indices.

  4. For quite a while now , economists and investors across the lobe have been expecting the Federal Reserve to raise the federal funds rate, in the light of an expected recovery of the U.S economy. The United States had reduced its funds rate to a benchmark zero in order to boost economic sentiment, in the face of the 2008 global economic meltdown. Since the rate hike signifies an upward swing in the U.S economy and has surfaced during a global economic slowdown in the face of European recessions and the Chinese economic meltdown, emerging market economies have been apprehensive of the fall-outs of this decision. With the rate hike, investor funds tend to flow into countries which garner greater profits and which offer greater stability. The emerging markets therefore predicted a spate of hot money flows out of their financial systems and into the coffers of the U.S Federal Reserve. Consequently, emerging market economies have been strengthening and stabilizing their economies in preparation for the after-effects of the Fed Rate hike. Although India was initially apprehensive of investor sentiment volatility in the wake of the rate hike, the market economy has managed to internalize the Fed's decision and has remained stable, with Sensex even recording a surge in stock value to a one-month high.

  5. The 2008 financial crisis , also known as the Global Economic Crisis due to its far-reaching impact was considered as the worst financial crisis of the world since the Great Depression of the 1930s. The genesis of the entire crisis lay in the U.S economy's mortgage market.The period post 2000 was of unusaul exuberance for the American economy. This resulted from the large inflow of foreign funds as investors withdrew large amounts from Russia and the East Asian economies and parked their funds in the United States. This withdrawal from the afore mentioned countries was a consequence of the Russian debt crisis and the East Asian crisis of 1997-1998. The enormous inflow of foreign funds into the American economy permitted increased levels of credit availability. Loans were indiscriminately provided for housing finance, construction, and mortgages, which led to a construction boom . This boom was further fuelled by increased consumer sentiment, as more and more people began to purchase houses due to easy availability of housing finance and mortgage loans from banks. It was self-fulfilling cycle, with easy credit increasing availability of homes, cheaper credit increasing the number of of people buying homes, and the number of houses constructed rising in tandem to cater to increased buyer sentiment. Banks and other financial institutions predicted the further rise in the prices and profits from the real estate sector and therefore began to create securitized instruments known as mortgaged backed securities. These mortgages were bundled into a single security and were bought by financial institutions at a discounted rate. Gradually however, people began to default on their loans and mortgages as their income was insufficient even to cover the interest rates. As more people began to default, banks accumulated bad loans that could not be retrieved. As a result banks began to restructure their bad assets by selling the mortgaged houses on the open market.By now however, buyers had caught wind of the impending crisi and investor sentiment had drastically fallen such that the prices of houses dropped to dramatically low levels. As a result banks were able to retrieve all but a fraction of the initial value of their now bad assets. With extremely low levels of available funds now, banks drastically restricted the provision of credit. Even worthy candidates had a hard time obtaining credit. Investor sentiments dulled due to lack of credit to industries, firms , corporates and individuals alike. This in turn reduced production, which adversely impacted demand and consumption and as the vicious cycle progressed prices dropped to historically low levels - the lowest since the 1930 Great Depression. The economy slowed down to a standstill and only began signs of revival with liquidity infusion programs to the tune of $2.5 trillion dollars by the Federal Reserve, the European Central Bank and other central banks cumulatively. President Barack Obama also introduced a series of regulatory measure against the shadow banking system that remained a major culprit in the entire debacle by providing loans and credit on an unregulated basis.

  6. In the wake of the slowdown in economic growth due to the 2008 housing bubble crisis, the Federal Reserve took many steps to inject liquidity into the economy as well as to revive consumer and investor sentiment, so as to boost economic activity and growth. One of the steps undertaken by the Fed was to reduce the interest rates charged on overnight loans provided by one financial institution to another from its reserve account with the Fed and on an uncollateralized basis. By reducing this fund rate to a benchmark zero the Fed effectively injected liquidity into the system by easing monetary restrictions and ensuring cheap and easy availability of credit. It was predicted that availability of cheaper credit would boost investor sentiment and credit off-take so as to revitalize economic activity and boost economic growth. Although care was taken to ensure collateral standards were met to prevent a repeat episode of the 2008 crisis, cheap credit was believed to be the quickest method to restart the economy by increasing the supply of money in the economy, which would in turn raise consumer and investor sentiment, and the levels of production in the economy.

  7. 10 --> Indian Ministry of Statistics and Programme Implementation determines the inflation rate of India. The report of August 2015 – the current inflation rate of India is 3.78% which is very modestly brought down from 9.1% in 2011, was determined by this agency.
    Broadly there are two indices to measure inflation in India: -
    • WPI – Whole sale Price Index
    • CPI – Consumer Price Index
    WPI – this index is the mostly used tool to measure Inflation in India. WPI analysis the price movement in the economy in the most comprehensive manner which is specifically used by the government banks, commercial banks, industries and business circles.
    Consumer price Index – it measure the price change from the perspective of the retail buyer and it is the real index for the common people because it reflects the actual inflation which is the product of an individual. CPI is adopted to measure the changes over time in the level of retail prices of selected goods and services which are the most common for the general consumers in the market.
    Other than these, we also use Whole Price Index (WPI); GDP Deflator is also used for the purpose of inflation indicator of the economy.

  8. 5. The thinking inside the Fed is that the economy is finally healthy enough that borrowing costs should return to more “normal” levels to help keep future inflation from accelerating too much.
    But it is a moment with challenges. It could send markets into a tizzy (if past experience is any guide), lead to a slower economic recovery and make it harder for workers to press for higher wages. For savers it could signal higher returns.
    Nearly seven years ago the Fed put its benchmark interest rate close to zero as a way to bolster the economy. And for months now, officials have said they might raise rates by the end of 2015. It’s a “liftoff” or “gradualism” strategy to implement programme step by step, so that, big investors will remain in the market and to be safe in the international economy which is currently associated with the U.S capital market. The last time the Fed raised interest rates, in June 2006.

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