Monetary Policy

Complete parts a, b, c, and d.

a. What is the most common tool of monetary policy?

b. Beginning in March of this year, what has the FOMC of the Federal Reserve, as have many other central banks throughout the world, as per the articles, done with regards to interest rates?

c. How will this change to interest rates affect AE and equilibrium GDP?Explain.

d. How will savings be affected by this change to interest rates worldwide?

Articles

Global Central Banks Ramp Up Inflation Fight

Central banks in the U.S., Europe, Canada and parts of Asia are lifting interest rates rapidly as they try to wrestle breakneck inflation under control.

ByJeanna SmialekandEshe Nelson The New York Times

PublishedJuly 17, 2022 UpdatedJuly 18, 2022,9:16 a.m. ET

Central bankers around the world are lifting interest rates at an aggressive clip as rapid inflation persists and seeps into a broad array of goods and services, setting the global economy up for a lurch toward more expensive credit, lower stock and bond values and potentially a sharp pullback in economic activity.

It's a moment unlike anything the international community has experienced in decades, as countries around the world try to bring rapid price increases under control before they become a more lasting part of the economy.

Inflation has surged across many advanced and developing economies since early 2021 as strong demand for goods collided with shortages brought on by the pandemic. Central banks spent months hoping that economies would reopen and shipping routes would unclog, easing supply constraints, and that consumer spending would return to normal. That hasn't happened, and the war in Ukraine has only intensified the situation by disrupting oil and food supplies, pushing prices even higher.

Global economic policymakers began responding in earnest this year, with at least 75 central banks lifting interest rates, many from historically low levels. While policymakers cannot do much to contain high energy prices, higher borrowing costs could help slow consumer and business demand to give supply a chance to catch up across an array of goods and services so that inflation does not continue indefinitely.

The European Central Bank will meet this week andis expected to makeits first rate increase since 2011, one that officials have signaled will most likely be only a quarter point but will probably be followed by a larger move in September.

Other central banks have begun moving more aggressively already, with officials from Canada to the Philippines picking up the pace of rate increases in recent weeks amid fears that consumers and investors are beginning to expect steadily higher prices a shift that could make inflation a more permanent feature of the economic backdrop. Federal Reserve officials have also hastened their response. They lifted borrowing costs in June by the most since 1994 and suggested that an even bigger move is possible, though several in recent days have suggested that speeding up again is not their preferred plan for the upcoming July meeting and that a second three-quarter-point increase is most likely.

As interest rates jump around the world, making money that has been cheap for years more expensive to borrow, they are stoking fears among investors that the global economy could slow sharply and that some countries could find themselves plunged into painful recessions.

Commodity prices, some of which can serve as a barometer of expected consumer demand and global economic health, have dropped as investors grow jittery. International economic officials have warned that the path ahead could prove bumpy as central banks adjust policy and as the war in Ukraine heightens uncertainty.

"It is going to be a tough 2022 and possibly an even tougher 2023, with increased risk of recession," Kristalina Georgieva, the managing director of the International Monetary Fund, said in ablog poston Wednesday. Ms. Georgieva argued that central banks need to react to inflation, saying that "acting now will hurt less than acting later."

Ms. Georgieva pointed out that about three-quarters of the institutions the fund tracks have raised interest rates since July 2021. Developed economies have lifted them by 1.7 percentage points on average, while emerging economies have moved by more than 3 percentage points.

In recent years, emerging markets have often raised interest rates in anticipation of the Fed's slow and steady moves to avoid big swings in their currency values, which depend partly on interest rate differences across borders. But this set of rate increases is different: Inflation is running at its fastest pace in decades in many places, and a range of developed-economy central banks, including the European Central Bank, theSwiss National Bank, the Bank of Canada and the Reserve Bank of Australia, are joining or may join the Fed in pushing rates quickly higher.

"It's not something we've seen in the last few decades," said Bruce Kasman, chief economist and head of global economic research at JPMorgan Chase.

The last time so many major nations abruptly raised rates in tandem to fight such rapid inflation was in the 1980s, when the contours of global central banking were different: The 19-country euro currency bloc that the E.C.B. sets policy for did not exist yet, and global financial markets were less developed.

That so many central banks are now facing off against rapid inflation and trying to control it by slowing their economies increases the chance for market turmoil as an era of very low rates ends and as nations and companies try to adjust to changing capital flows. Those changing flows can influence whether countries and businesses are able to sell debt and other securities to raise money.

"Financial conditions have tightened due to rising, broad-based inflationary pressures, geopolitical uncertainty brought on by Russia's war against Ukraine, and a slowdown in global growth," Janet L. Yellen, the U.S. Treasury secretary, said in a speech last week. "Now, portfolio investment is beginning to flow out of emerging markets."

For financial markets, the adjustment to higher interest rates could be "bumpy, there's no way around that," said George Goncalves, head of U.S. macro strategy at MUFG Securities Americas. And as rates move higher, stock and other asset prices may drift lower in a lasting way, as savers can receive higher paybacks on less-risky investments, like government debt.

"The incentive was to chase yield, and that would push markets to higher valuations than they would have had based on fundamentals," Mr. Goncalves said.

The simultaneous action also ramps up the risk that some nations could fall into a recession as consumers and companies pull back their spending.

Mr. Kasman estimates that the United States and Western Europe have a 40 percent chance of a recession within the next year. That risk stems both from central bank moves and upheaval from Russia's war in Ukraine, which shows no signs of ending. But if the recession can be averted now leaving unemployment low, consumers still spending and inflation elevated it could mean that the Fed and other central banks have to raise rates more later on to choke off growth and bring price increases down, he said.

Fed officials have said they still aspire to engineer what they often call a "soft landing," in which hiring and spending cool down enough to allow wage growth and prices to moderate, but not so much that it plunges the economy into a deep and painful downturn.

But inflation has proved uncomfortably stubborn. The latest Consumer Price Index reading in the United States exceeded analyst expectations at 9.1 percent. In Canada, inflation is running at itsfastest pace since1983. In the United Kingdom, it is similarly ata 40-year-high.

That underscores that global factors, including a constrained supply of consumer goods like cars and clothing and a spike in oil and food costs, are prompting much of the price surge. It also explains why so many central banks are staging a similar and faster response, even if doing so increases the risk of a recession.

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The Bank of England was the first major central bank tokick off rate increases back in Decemberand has been steadily raising rates since. Policymakers are increasingly worried about inflation creating a cost-of-living crisis in Britain and worry that higher rates could compound economic pain. At the same time, they have signaled that they couldact more forcefully, taking their cue from their global peers. There is a "willingness should circumstances require to adopt a faster pace of tightening," Huw Pill, the chief economist of the Bank of England,said this month.

"Many central banks are looking at this as a sort of existential question about getting inflation and inflation expectations down," said Matthew Luzzetti, chief U.S. economist at Deutsche Bank.

The Fed raised rates by a quarter point in March, half a point in May, and three-quarters of a percentage point in June. While its officials have predicted that they will maintain that pace in July, they have also been clear that an even bigger rate increase is possible.

"Inflation has to be our focus, every meeting and every day," Christopher Waller, a Fed governor, saidduring a speechlast week. "The spending and pricing decisions people and businesses make every day depend on their expectations of future inflation, which in turn depend on whether they believe the Fed is sufficiently committed to its inflation target."

The Bank of Canada has already gone for a full percentage point move, surprising investors last week with its largest move since 1998, while warning of more to come.

"With the economy clearly in excess demand, inflation high and broadening, and more businesses and consumers expecting high inflation to persist for longer, the Governing Council decided to front-load the path to higher interest rates," the central bank's policy-setting councilsaid in a statement.

The central bank in the Philippines also surprised investors with a three-quarter point increase this month, and an arrayof other central bankshave made big moves. More action is coming. Central banks around the world have been clear that they expect to keep moving borrowing costs higher into the autumn.

"I wouldn't say we're at peak tightening quite yet," said Brendan McKenna, an economist at Wells Fargo. "We could go even more aggressive from here."

A key question is what that will mean for the global economy. The World Bank in Juneprojected in a report that global growthwould slow sharply this year but remain positive. Still, there is "considerable" risk of a situation in which growth stagnates and inflation remains high, David Malpass, head of the World Bank, wrote.

Ifinflation does become entrenched, or even show signs of shifting expectations, central banks may have to respond even more aggressively than they are now, intentionally crushing growth.

Mr. Kasman said the open question, when it comes to the Fed, is: "How far have they gone toward the conclusion that they need to kick us in the teeth, here?"

Europe Joins Fight Against Inflation, Raising Rates for First Time in 11 Years

ByEshe Nelson The New York TimesJuly 21, 2022

FRANKFURT As consumer prices across Europe soar at the fastest rate in generations, officials in Frankfurt on Thursday took a powerful step to control rapid inflation amid mounting concerns over an economic slowdown.

In the first move of its kind in over a decade, the European Central Bank raised its three interest rates half a percentage point, an increase that was twice as large as telegraphed and that follows similar measures taken by the Federal Reserve anddozens of other central banks around the world this year.

The global outlook has worsened in recent months, as inflation rises in seemingly every corner of the economy and pandemic-induced disruptions continue to wreak havoc on supply chains. For the eurozone, the bloc of 19 countries that use the euro, the dimming outlook has been particularly acute.

With war on its doorstep, and as the cost of powering businesses, heating homes and feeding families becomes increasingly unaffordable, the European Central Bank is grappling with profound uncertainty. Christine Lagarde, the bank's president, gave few signals on Thursday about what comes next.

Consumer prices in the eurozone rose on average 8.6 percentlast month from a year earlier. The last time inflation was this bad in the region, the euro didn't exist. That has placed the European Central Bank in uncharted territory.

"Inflation continues to be undesirably high" and is expected to remain so for some time, Ms. Lagarde said at a news conference on Thursday. The latest economic data "indicate a slowdown in growth, clouding the outlook for the second half of 2022 and beyond," she said.

Amid fears over Europe's energy supply from Russia, and with the economic outlook worsening, the central bank said it chose to "front-load" its rate increases. In one swoop, the bank ended an eight-year era of negative interest rates a policy dating to 2014, when the concern was too-low inflation and banks needed to be encouraged to lend more generously.

The European Central Bank has acted more slowly to rein in inflation than some of its international peers, such as those in Britain and Canada, because it has been hit harder by sources of inflation that are out of its control, such as the global supply chain disruptions and rising energy prices caused by Russia's invasion of Ukraine.

Policymakers in Europe have also been more cautious than those at the Federal Reserve in the United States, where tight labor markets and strong consumer demand mean officials need to cool the economy.

"The E.C.B. is still deploying a distinctly more accommodative monetary policy than other major central banks," Wolfgang Bauer, a fund manager at M&G Investments, wrote in a note.

The bank's deposit interest rate is at zero, but the key policy rate in Britain is 1.25 percent and the Fed's is set to a range of 1.5 to 1.75 percent. "If inflation continues to reign supreme, there is still a lot of catching up to do," Mr. Bauer wrote.

Ms. Lagarde said an "updated assessment of inflation risks" had led to the decision to raise rates by double the amount forecast at its last meeting. Another reason, she said, was the bank's approval of a new policy tool aimed at preventing "unwarranted" disparities in eurozone countries' borrowing costs that would impede the effectiveness of monetary policy.

The increase in inflation in June was more than the bank had predicted, and last week, theeuro fell to parity with the dollarfor the first time in 20 years. That added to the bloc's inflationary pressures because the lower currency value increased the cost of imports.

Even after the unexpected half-point increase, the bank "is moving much too slowly toward an interest rate level that is appropriate in view of high inflation," Jrg Krmer, the chief economist at Commerzbank, wrote in a note to clients.

Policymakers raised the deposit rate, which is what banks receive for depositing money with the central bank overnight, from minus 0.5 percent to zero. Further rate increases are likely to come at subsequent meetings, the bank said, but future decisions will be made at each meeting depending on data. The bank has a target of 2 percent inflation over the medium term and didn't give any signals on how big future increases might be.

At her news conference, Ms. Lagarde took pains to lay out all of the economic clouds gathering: Growth was slowing down, the war in Ukraine was a drag on growth, high inflation was increasing the cost of living, and businesses were facing higher costs and continued supply chain disruptions.

But the central bank's mandate is price stability, so acting to ease inflation must be seen to be its priority, even as price increases vary wildly across the bloc. Inflation ranges from around 6 percent in Malta to over 20 percent in Estonia.

Raising interest rates was the crucial next step in ending the European Central Bank's era of ultraloose monetary policy support. The bank has already ended its multitrillion-euro programs to buy bonds. The rate increases will go into effect on Wednesday.

On Thursday, the bank also introduced a policy tool to limit the divergence in borrowing costs across the eurozone's 19 members, which it said was part of the reason it was able to raise interest rates more than expected. Tightening monetary policy had revived investors' concerns about the fiscal stability of the bloc's most indebted members.

In recent months, rapidly rising borrowing costs for Italy, which has the second-highest debt burden in the eurozone, intensified the focus on whether bond market moves were in line with economic fundamentals or speculative trading that threatened the effectiveness of monetary policy. That assessment was complicated even further on Thursday when Mario Draghi, Ms. Lagarde's predecessor at the central bank,resigned as prime minister of Italy. After just 17 months, the coalition government he led in an effort to bring about economic reforms fell apart.

The bank's new policy tool, theTransmission Protection Instrument, is intended to stop disorderly moves in government bond markets. In short, the new tool will allow the bank to buy the bonds of countries it believes are experiencing an unwarranted deterioration in financing conditions. But as there was when an earlier policy instrument was announced in the depths of the 2012 European debt crisis, there is a hope that the announcement alone will calm bond markets and that the tool will not have to be used.

The last time the bank raised rates, in July 2011, policymakers reversed the move just four months later as a crisis in the region's bond markets intensified.

These days, policymakers are walking a fine line between easing price pressures and drawing the European economy into a recession. And analysts are questioning how high the bank can raise rates before the economic outlook deteriorates too much and the bank has to stop. Ms. Lagarde said on Thursday that the larger-than-expected rate increase didn't change how high the bank expected to raises rates overall, though she didn't say what rate the central bank was aiming to reach. Analysts at Commerzbank expect rates to peak at 1.5 percent next spring.

Concern is growing that the bloc will enter a recession, especially if Russian natural gas supplies are cut off or gas rationing hampers industrial production, halting rate increases sooner than expected. On Wednesday, the European Commission urged member countries toimmediately start rationing the use of the fuelto avoid energy shortages that would stall economic growth and leave households cold in the winter.

"An economic downturn is ahead, and the question is more about the extent of that downturn," said Nick Kounis, the head of financial markets and sustainability research at ABN Amro. "Right now, of course, the focus is very much on inflation, but if they do get into a situation where the economy is stagnating or even contracting and unemployment starts to rise significantly, that could start to change the balance of the risks."