The U.S. Federal Reserve pause in rate hikes

(Mainsgs3:Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment.)

Context:

• Recently, the U.S. Federal Reserve (Fed) last week paused its rate hike cycle by deciding to hold interest rates after ten rate hikes since March 2022. 

Targeting interest rates:

• Central banks around the world try to steer their economies primarily by targeting interest rates at which lending/borrowing happens in the short-term credit markets. 
• For example: If a central bank wants to lower short-term interest rates, it can enter the market where banks borrow funds for their short-term needs with fresh funds, bid up the price of these loans and thus lower interest rates. 
• The fresh money injected into the banking system, in turn, would tend to percolate into the economy and cause prices to rise in the wider economy. 
• A central bank can thus use monetary policy to influence prices in the wider economy and keeping inflation within a certain target range is a major goal of central banks.

Economy operating full capacity:

• Another policy goal that central banks try to meet along with the inflation target is to keep the economy operating at its full capacity wherein all resources are fully employed. 
• Many economists believe that there is a trade-off between inflation and unemployment. 
• According to this framework, if inflation falls too low, this can cause a rise in unemployment and hence unused capacity. 
• So, the agenda of most central banks is to keep inflation up at a certain level at which the economy functions at full capacity. 
• Inflation above a certain level, however, is seen as having no positive effect on economic activity.

Curtailing inflation:

• The Fed began raising interest rates after inflation hit multi-decade highs as the U.S. economy slowed down due to the Covid-19 lockdowns and the U.S. central bank responded by flooding the economy with massive amounts of dollars. 
• Now, the central bank is waiting for signs that there has been a decisive slowdown in inflation before it decides on further actions. 
• It must also be understood that the effects of monetary policy usually take time to show up in terms of their impact on prices in the wider economy.

Conclusion:

• It is hard to predict the trajectory of economic indicators such as growth and inflation, or even the response of central banks with any level of certainty since there are multiple complex variables at play at the same time.