Keeping up with the Feds

How the Federal Funds Rate Works

The federal funds rate is set by the Federal Open Market Committee (FOMC), which meets eight times a year. The FOMC comprises 12 members, including seven governors of the Federal Reserve Board and five presidents of the regional reserve banks. At each meeting, the committee votes on whether to increase, decrease or leave unchanged the target federal funds rate. The target rate is announced after each meeting, along with any changes to monetary policy.

Voting for the monetary policy action were Jerome H. Powell, Chair; John C. Williams, Vice Chair; Michael S. Barr; Michelle W. Bowman; Lael Brainard; James Bullard; Susan M. Collins; Lisa D. Cook; Esther L. George; Philip N. Jefferson; Loretta J. Mester; and Christopher J. Waller.

Let's go over the key highlights of the FOMC meeting from Nov 1-2, 2022 to understand the Feds.

There are signs that people are spending and producing more, which is good news. People are getting jobs more easily, and the unemployment rate is staying low. However, inflation is still high because there are imbalances in the economy related to the pandemic, higher prices for food and energy, and other factors.

In order to understand how increased spending and production can impact inflation, we first need to understand what inflation is. Inflation is the rate at which the prices of goods and services increase. It's important to note that not all prices increase at the same rate. Some prices may increase faster than others.

There are a number of factors that can cause inflation. One of those factors is increased spending. When people have more money to spend, they're more likely to buy things. This increase in demand can cause prices to go up. Another factor that can cause inflation is increased production. When companies produce more goods and services, they often need to raise prices in order to cover their costs.

Additionally, the war in Russia is causing a lot of human suffering and economic difficulties, which is adding to inflationary pressures and weighing down on the global economy.

The war is causing energy and food prices to go up really fast, which is making things more expensive overall and making it hard for the economy to grow. People are worried that Europe's energy crisis could worsen if Russia decreases natural gas supplies or turns off the gas completely. This would cause production problems all around the world, given the relative economic dependency.

The Committee wants to target inflation at 2% long term (from the current 8.2%).

Why the target is 2% inflation and not zero?

One reason that central banks have chosen a target number for inflation that is above zero is that it is hard to measure inflation accurately. The indexes used to estimate inflation do not include all of the goods and services in an economy. Also, these indexes usually show slightly higher prices than what is really happening. For example, if the observed inflation rate is 1 or 2 percent, the true measure is probably closer to zero.

Some people think that it is good to have a positive inflation target because interest rates and inflation are usually proportional. This means that when there is a higher inflation rate, there is also a higher interest rate. Having a higher interest rate gives the Fed (Federal Reserve) more room to lower rates in the event of a recession. This way, monetary policy can operate more through its traditional interest rate channel.

Another argument is that it is important to have a positive inflation rate so that there is insurance against deflation. Deflation is when prices for goods and services go down for a long time due to a decrease in demand for goods and services. This decrease in demand can cause businesses to lay off workers or even go out of business. As more businesses close their doors, unemployment rates increase, and people have even less money to spend, leading to even lower demand and further deflation. This downward spiral is called a deflationary spiral, and it can be very difficult to break out of once it starts. Some people think that it would be more harmful to have deflation than to have a positive inflation rate. This means that it is better to have a small positive inflation rate than no inflation or negative inflation.

To help these goals, the Committee raised the target range to 3-3/4 to 4 percent for the federal funds rate.

One of the most important tools the Federal Reserve has at its disposal to manage inflation is the federal funds rate. This is the rate that banks charge each other for overnight loans, and it is closely linked to the prime rate, which is the rate that banks charge their best customers. When the Fed wants to slow down the economy and reduce inflation, it raises the federal funds rate. The higher cost of borrowing then acts as a brake on economic activity and can help bring inflation back down to target levels.

Why Stock Market doesn't like the federal fund rate increase?

When the Fed raises rates, it means companies will have to pay more for things like raw materials and labor, eating into their profits. As investors become worried about slower profit growth, they'll sell stocks and push prices lower.

Higher interest rates also make it more expensive for companies to borrow money for expansion. That means they're likely to rein in spending plans, which can lead to job cuts. As consumers see their friends and neighbors losing their jobs, they'll become more cautious with their spending, exacerbating the problem. All of this uncertainty can send stocks tumbling.

Also, the market was eager to hear about the Fed Pivot. A Fed pivot typically happens when economic conditions have fundamentally changed in such a way that the Fed can no longer continue its prior policy stance. In this case, a pivot would be lowering the increase in the fed fund rate significantly or even lowering the fed fund rate altogether.

But the Feds maintained that they will have to continue for longer to control inflation.

This has brought back fear of recession.

What is a recession?

A recession is a significant decline in economic activity spread across the economy, lasting more than a few months but could also be in years (if unchecked) and normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

The balancing act that the Feds will have to play is this: A reduction in interest rates makes it cheaper for firms to borrow money for investment and encourages consumers to take out loans for big-ticket purchases. This increase in borrowing and spending will help boost aggregate demand and prevent a recession. But a premature interest rate reduction will not cause inflation to come down.

What to expect from the next FOMC?

The Feds tried to address the fears people have at a news conference. Fed chair Jerome Powell said that they will keep raising rates till inflation is under control. This might be more than what they said in September. But he also said the Fed could stop at a half-point hike when they meet again in December. Then, early next year, the Fed could do a quarter-point increase instead, which is more typical.

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