Quantitative tightening stirs up headwinds for economic growth
US Federal Reserve, has reiterated the Fed’s commitment to bringing down inflation to its preferred level of 2%. “We must keep at it until the job is done," Powell said on Friday, implying that interest rates will remain high until the Fed is confident that it has a firm grip on bringing down inflation. The Fed tries to control inflation by raising the federal funds rate, the interest rate at which banks in the US lend money to each other on an overnight basis.
The hope is that higher rates will dampen consumer demand and corporate investment, helping control inflation. Among other things, an increase in corporate investment puts pressure on wages and pushes up overall inflation. An increase in the federal funds rate tends to push up short- to medium-term rates.
Nonetheless, long-term interest rates also need to go up if the Fed really hopes to dampen consumer demand through a lower disbursal of home loans and discourage corporates from taking more loans for investments. Since November 2008, the Fed has driven down long-term interest rates to encourage consumption and investment. This started a few weeks after Lehman Brothers—then the fourth largest investment bank in the world—declared bankruptcy.
The Fed drove down interest rates by printing money—or rather creating it digitally—and using it to buy bonds. This mechanism is called quantitative easing (QE). It ensures that newly-created money is pumped into the financial system, pushing down long-term interest rates.
Other rich-world central banks soon followed suit. The Bank of England started QE in March 2009, which was followed by the Bank of Japan and European Central Bank as well. In fact, once the covid pandemic struck, the central banks increased QE to levels
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