IA Plan document

Article Title: US raise interest rates despite banking turmoil

Article Source: bbc.com

Article URL: https://www.bbc.com/news/business-65041649.amp

Date Published: 22nd of march 2023

Date commentary was written:

Word count: 854

Key concept: Intervention

Section of the syllabus: Macroeconomics

The US central bank has raised interest rates again, despite fears that the move could add to

financial turmoil after a string of bank failures.

The Federal Reserve increased its key rate by 0.25 percentage points, calling the banking

system "sound and resilient".

But it also warned that fallout from the bank failures may hurt economic growth in the months

ahead.

The Fed has been raising borrowing costs in a bid to stabilise prices.

But the sharp increase in interest rates since last year has led to strains in the banking system.
Two US banks - Silicon Valley Bank and Signature Bank - collapsed this month, buckling in part

due to problems caused by higher interest rates.

There are concerns about the value of bonds held by banks as rising interest rates may make

those bonds less valuable.

Banks tend to hold large portfolios of bonds and as a result are sitting on significant potential

losses. Falls in the value of bonds held by banks are not necessarily a problem unless they are

forced to sell them.

Authorities around the world have said they do not think the failures threaten widespread

financial stability and need to distract from efforts to bring inflation under control.

Last week, the European Central Bank raised its key interest rate by 0.5 percentage points.

The Bank of England is due to make its own interest rate decision on Thursday, a day after

official figures showed that inflation unexpectedly shot up in February to 10.4%.

Federal Reserve chairman Jerome Powell said the Fed remained focused on its inflation fight.

He described Silicon Valley bank as an "outlier" in an otherwise strong financial system.

But he acknowledged that the recent turmoil was likely to drag on growth, with the full impact

still unclear.

Economic impact

Forecasts released by the bank show officials expect the economy to grow just 0.4% this year

and 1.2% in 2024, a sharp slowdown from the norm - and less than officials projected in

December.
The announcement from the Fed also toned down earlier statements which had said "ongoing"

increases in interest rates would be needed in the months ahead.

Instead, the Fed said: "Some additional policy firming may be appropriate".

The moves "signal clearly that the Fed is nervous", said Ian Shepherdson, chief economist at

Pantheon Macroeconomics.

Wednesday's rate rise is the ninth in a row by the Fed. It lifts its key interest rate to 4.75%-5%,

up from near zero a year ago - the highest level since 2007.

Higher interest rates mean the cost to buy a home, borrow to expand a business or take on

other debt goes up.

By making such activity more expensive, the Fed expects demand to fall, cooling prices.

That has started to happen in the US housing market, where purchases have slowed sharply

over the last year and the median sales price in February was lower than it was a year ago - the

first such decline in more than a decade..

But overall the economy has held up better than expected and prices continue to climb faster

than the 2% rate considered healthy.

Inflation, the rate at which prices climb, jumped 6% in the 12 months to February. The cost of

some items, including food and airfare, is surging even faster

Before the bank failures, Mr Powell had warned that officials might need to push interest rates

higher than expected to bring the situation under control.

The bank projections show policymakers expect inflation to fall this year - but less than

expected a few months ago.

Still, they forecast interest rates of roughly 5.1% at the end of 2023 - unchanged since

December - implying the Fed is poised to stop raising rates soon.

Mr Powell described the effect of the recent turmoil as the "equivalent of a rate hike".

He said the Fed may be able raise its key rate less aggressively, if the turmoil in the financial

system prompts banks to limit lending, and the economy to slow more quickly.

But he repeated that the Fed would not shy away from its inflation fight.

"We have to bring down inflation down to 2%," he said. "There are real costs to bringing it down

to 2% but the costs of failing are much higher."

Commentary

Due to the current state of soaring inflation, the Fed has intervened in the economy by

implementing a contractionary monetary policy to stabilize the economy and control inflation to a

desired rate by “2%”. This commentary will evaluate the effectiveness of the intervention.

In the start of 2023, the USA saw its inflation rate “jump to 6% in the 12 months to February”.

With the aim of stabilizing inflation rates at a “healthy rate of 2%”, the Fed aims to intervene

with contractionary monetary policy by lifting its key interest rate by “4.75%-5%”. As a response

to inflation, the intervention requires the Fed to manipulate the money supply in the economy

by the influence of interest rates. In an inflationary gap, caused by demand-pull inflation, shown

by the difference between AD2 and AD1, the Fed has increased interest rates to indirectly

reduce consumer spending ( C ) and investment spending ( I ) hence shifting aggregate

demand from AD1 to AD2, ceteris paribus. As interest rates increase, the cost of borrowing

increases, disincentivizing those who are borrowing to consume and those borrowing to invest,

thereby reducing aggregate demand and real national output and slowing down the circulation

of money in the economy.

The shift caused by the intervention has resulted in a reduction of price level in the economy

from Pl 1 to Pl 2 which closes the inflationary gap, where such impact has been seen in the “US

housing market”. A shift of AD also sees a shrinkage in real national output from Y1 to Yfe

where actual output no longer exceeds potential output, this might pose as a threat towards

economic growth as real GDP did not increase in the short run (movement towards the PPC),

nor the long-run (shift of the PPC) but rather sees a decrease in real GDP. A decrease in output

also infers an increase in unemployment of the economy. However, if the shift of AD is

measured to be correct so that AD2 is at the full employment level of output then the economy

will operate at the natural rate of unemployment where there is no cyclical unemployment.

The intervention of a contractionary monetary policy has had its effect on various stakeholders.

Firstly, an interest rate-dependent industry of housing has seen a decrease in sales price for the
first time in the past decade. This is evidence of how the intervention has been shown to be

effective in some business sectors of the US where a reduction in interest rate has seen a

decrease in borrowing and spending for finished goods and therefore, leading to a decrease in

sales price. However, “prices continue to climb faster than the 2% rate considered healthy” and

the contractionary monetary policy has not seemed to create as great of an impact towards the

overall economy of the US. This might be a result of the indirect impact of a monetary policy

compared to other demand-side policies that have more direct manipulation of aggregate

demand, as monetary policy relies on the confidence of consumers and businesses to spend

less in order to decrease aggregate demand.

With the economic unrest caused by the “financial turmoil after a string of bank failures”, the

increase in interest rate could amplify the situation as two banks have failed to cope with

problems arising from high interest rates causing their fallouts. Despite reassuring that the US

banking system is “sound and resilient”, there are still risks of future problems for commercial

banks of the US when the key rate has again been intervened and raised by the Federal

Reserve. However, bonds held by banks have an inverse casual relationship with interest rates

and will see a decrease in value once the key rate has been raised causing banks that “hold

large portfolios of bonds'' to experience a decrease in value as the return interest rate is fixed

and can lose value due to a higher interest rate.

Evidence of how the intervention of a contractionary monetary policy has affected the overall

economy of the US has been shown when the expected rate of economic growth of 2023 and

2024 is described as “a sharp showdown from the norm” and “less than officials projected”.

Again, if calculated correctly, aggregate demand could possibly be at the full employment level

of output which is likely to be at the aim of 2% inflation that the Fed had announced, then the

intervention might create confidence towards potential investments by the private sector or the
government, hence leading to economic growth. However, this could be very difficult to achieve

to firstly calculate interest rates to match the full employment level of output but to do so in a

state of economic unrest.

In conclusion, the intervention with the aim to combat inflation done by increasing interest rates

is heavily dependent on the reduction of spending of the economy. With the results being seen

where prices are still climbing higher than 2%, the Fed should rethink whether another increase

in interest rates would yield significant results, especially in a situation of financial turmoil that

the economy has been in with the fallout of two banks.