Recently, the US Federal Reserve raised interest rates to control rising inflation. Why should inflation be controlled? Simply put, inflation means you will have to pay more to buy the same goods. When people have more money to spend from their pockets, sellers tend to raise the prices of goods, and people are willing to buy them even though they are sold at higher prices. So, one way to control the rising prices of goods and services is to somehow reduce the flow of money in the economy. Thus, by raising interest rates, the Federal Reserve encourages people to deposit their money, thereby reducing the flow of money in the market. As a result, people spend less than before to purchase goods and borrow less. This mindset of consumers leads to a reduction in corporate profits. In turn, companies start laying off employees to minimize the loss. Unemployment worsens the situation when spending goes down further, leading to a negative cycle.
This negative cycle of events is known as a recession. It is a temporary decline in the economic activities of a country, during which trade and industrial activities are reduced. Thus, the government needs to know that the country is about to slip into recession so that it can take counteractive measures to avoid total economic collapse. How do we know if a recession is about to take place?
Currently, in the US, the last two-quarters of GDP has declined, unemployment rates have increased, existing house sales have declined, and the yield of the 10-year bond is less than that of a 2-year bond. These are the indicators of an upcoming recession. This has also happened many times in the past, and the inverse curve of bond interest has correctly predicted a recession a few times in the past.
The effect of the upcoming recession on the rest of the country has been very visible. In India, the rupee vs. dollar exchange rate crossed Rs 80 per dollar. As the US Federal government increased interest rates, investment by FII (Foreign Institutional Investors) took a hit. This means that there was an outflow of money from the developing countries, which resulted in the devaluation of their currencies. Since the US is the biggest consumer in the world, if its economy gets hit, then the exports of all the other countries will be affected.
Hold on! There is still hope as the initial unemployment claim rate is slowing down, per recent weekly data. Inflation is also edging lower, and this may hold banks from increasing their interest rates.
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