Thursday May 05, 2022

Central banks raise interest rates to fight inflation

Central banks raise interest rates to fight inflation

The Reserve Bank of India has also increased intererest rates to deal with rising inflation.

The central banks across the world seem to have woken up to the reality of rising inflation, and they are using the one weapon in their hands, the interest rate, to tame inflation. The United Federal Reserve’s Federal Open Market Committee (FOMC) has raised interest rate by 50 basis points on Wednesday, that is by half-a-point (100 basis points mark one point), the highest since 2000. Fed Chair Jerome Powell said that there would be similar 50 basis points raises in the next two rounds.

This will also reduce the holdings of the Treasury and the mortgage-backed securities, which the Treasury had mopped as a way to support the market during the COVID-19 epidemic. The Treasury will let go of its holdings gradually, at the rate of $ 47.5 billion every month, and increase the offloading to $95 billion in three months. Fed chief Powell simply said of the decision to raise the interest rate: “Inflation is much too high and we understand the hardship it is causing and we are moving expeditiously to bring it back down.”

Inflation in America has been at a 40-year high, and the personal expenditures price index stood at 6.6 per cent in March, and the consumer price index was 8.6 per cent. The Fed’s targeted range for inflation is up to two per cent, and this is way too high. Powell said, “Yes, there may be some pain associated with getting back to that. But the big pain is not dealing with inflation and allowing it to become a contraction.” If inflation becomes monstrous, then all economic activity would come to a standstill because no one would have enough money to spend on anything.

Americans remember Paul Volcker, another Fed Chair in the 1980s, raise interest rates to 20 per cent to put inflation down, and in the process he had unwittingly triggered recession. Americans do not want a Volcker solution though they do want the inflation to be tamed. That is why, the Fed is raising the interest rate by bits so that it does not hurt the economy. There was an apprehension that the Fed might raise the rates by 75 basis points or even one point. If the interest rates are too high, then neither businesses nor individuals would borrow money from the banks to run businesses and to buy things and take vacations which are so essential to keep the American economy chugging.  

Interestingly, the Saudi Arabia central bank, SAMA, raised the interest rate by 50 basis points in tandem with the US Fed move. The bank said in a statement: “In line with the Saudi Central Bank’s objective of maintaining monetary and financial stability, the Saudi Central Bank has decided to raise the Repurchase Agreement rate by 0.5 per cent to 1.75 per cent from a previous 1.25 per cent, and the Reverse Repurchase Agreement by 0.5 per cent to 1.25 per cent from a previous 0.75 per cent.”

India’s Reserve Bank of India’s Monetary Policy Committee (MPC) had suddenly raised interest rated by 40 basis points, from 4 per cent to 4.40 per cent. RBI Governor Shaktikanta Das said this was done to deal with inflation without hurting the growth prospects. The Indian central bank had shied away from raising interest rate to make it easy for businesses and individuals to borrow from the banks in the difficult times of the pandemic in 2020 and 2021. But in the last few months, inflation in India had been edging up, and the RBI in an emergency meeting on Wednesday intervened to hike the bank rate. The Bank of England hiked the rate by 0.25 per cent to take the interest rate to 1 per cent, fearing that inflation would enter double digit territory. It stood at 7 per cent in March.

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