US Federal Rate Hike and Its Impact

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Fed Rates or the Federal Fund rates are those interest rates in United States at which on depository institution lends out to other depository institutions without any collateral security. It is the rate at which Federal Funds are lent out overnight.  Banks hold reserve requirement with the local Fed Authority or in their respective vaults. When the banks are out or falling short of cash, it borrows the deficit amount from this reserve. The amount which is loaned and borrowed is eventually called the Federal Funds.

IMPORTANCE OF US FEDERAL RATE

The United States being one of the most developed economies is required to maintain the Fed Rates. The Federal Reserve uses the Fed funds as a tool to control economic growth in the United States. This rate is one of the most important rates as it determines inflation and employment. It usually regulates the monetary and financial conditions of an economy. The federal Open Market Committee or FOMC meets eight times a year. The FOMC decides on the federal rates. The FOMC increases the fed fund rate which decreases the money supply in the economy eventually increasing the rate. The increase of fed rates is usually done to cool inflation and during expansionary period. The banks keep an end-of-day balance in record so that if there is an excess end-of-day balance in one bank’s account, it can easily give out the excess amount to another bank which is facing a deficit in the end-of-day balance.

The Fed rates have been revised and increased to 2.00% from 1.75%. The Fed rate has been increased for the seventh time since 2015.

IMPACT ON THE US ECONOMY

The officials are in expectation to curb down inflation by increasing the borrowing cost. Officials have estimated that the median economic growth would be around 2.7 percent. They also expect unemployment to fall to 3.8 percent and 3.6 percent by 2019.  The unemployment had fallen to the level which the Fed had expected after the year end. It has eventually increased the federal expenditure and caused huge tax cuts. The targets are therefore achieved and it is one of the most important indicators for inflation and economic growth in US as stated above.

IMPACT ON THE WORLD ECONOMY

The retreat from emerging markets remains relatively modest, with weekly flows to bond and equity funds down less than 10% from their peaks, according to EPFR Global, part of research firm Informa. But it has coincided with a stronger dollar, contributing to currency crises in countries such as Argentina, Turkey and Brazil. It has also prompted central banks elsewhere, including in Indonesia, Malaysia and Hong Kong, to raise their own interest rates in defence.

In the currency markets, the US dollar touched its highest level in May since December 2017. The euro slid significantly against the dollar reflecting a combination of factors, including tepid growth data for the Euro Area, and political uncertainty in its southern periphery, including Italy. EME currencies have, by and large, depreciated against the US dollar.

IMPACT ON INDIAN ECONOMY

As the Fed rate is one of the most important rates that are used in the market, it also affects the Indian economy. The RBI’s Monetary Policy Committee had increased the repo rate by 25 basis points which eventually signalled the reversal of the easy monetary rate policy. It seemed that it was done partly because of the rise of the Fed rates. Indian markets also have witnessed outflows of about Rs 40000 crore. Foreign investors were taking the advantage of mispricing due to the difference of rates.

Equity market performance has varied across regions, with the Advanced Economies (AEs) clocking modest gains on strong first quarter earnings and abating of trade tensions, while stocks in major Emerging Market Economies (EMEs) have faced selloffs on a rising dollar and expectations of further rate hikes by the Fed.

The rupee is at its weakest when it is compared to dollar. The current rate is 71 INR/USD.

The expected impacts are:

  1. Weakening of the rupee against dollar

The Fed rate hikes can make rupee weaker which would eventually bring down the imports in the country making it quite expensive.

  1. Bond market pressure

Due to the hike in Fed Rates, the US bond yields are expected to rise and this would put pressure on the Indian bonds as well.

  1. Slower inflow

As the Fed rates are hiked, the interest rates have risen. This would demotivate the foreign investors from investing in India. This would also reduce the FDI. Thus, a slower inflow would occur.

Author | Shohom Pal