Testifying before the US Congress, Federal Reserve chairman Jerome Powell indicated yesterday, that the Central Bank is likely to lower the Fed funds rate below 2.50 despite strong growth in the recent job numbers. Latest reports by the Labor Department revealed a jaw-dropping 224,000 jobs being added in the month of June. In a surprising move, Democrats had recently proposed doubling the minimum wage to $15 an hour from the existing $7.25 per hour.
Is A Rate Cut Essential Now?
The world economy is facing unprecedented growth challenges. Bond markets are witnessing flat yield curves and trade tensions are on the rise. Chairman Powell highlighted that muted inflation and the possibility of a global economic slowdown had forced policymakers to agree about lowering rates in the June meeting.
How Will A Wage Hike Impact The Economy?
A recent report released by the Congressional Budget Office indicated that the purpose of hiking the minimum wage is to improve the livelihood of people and put the US economy back on a growth trajectory. However, there are higher chances that a steep wage hike is more likely to defeat the purpose. It will rather lead to massive job losses by the year 2025. The budget office also stated that approximately 1.3 million people were likely to lose their jobs if the move is rolled out. Adverse impacts like reduction in business income and price hikes for consumers are likely to mute the overall growth of the economy in the long run.
What Tools Are Available With The Fed?
One of the Primary tools that Chairman Powell highlighted yesterday was the interest on excess reserves or what is commonly known IOER. Excess reserves are funds that a bank keeps back beyond what is required by regulation.
Prior to 2008, banks were not paid any interest on excess reserves. The new rule was implemented effective 2011. Post Oct. 2011, banks were rewarded for holding excess reserves at the Federal Reserve. This also helped reduce the chances of a default. The Fed alters the IOER depending on the prevailing liquidity situation in the economy. The differential between the interest on excess reserves and the Fed funds rate help the central bank keep inflation targets on track. Take for example, if the Fed raises rates by 25 bps, while the IOER is hiked by 20 bps. This gap is used as a policy tool to keep the economy from overheating or slowing down in the near term. If the economy heats up too fast, the Fed pushes up the IOER and vice versa.