When America sneezes the world catches a cold! I am sure you must have heard this ample times ever since the 2008 recession. The US has been a global leader and its policy affects the entire world. Most of the world trade is carried with the help of US dollars which serves as a medium of exchange to facilitate trade. The dollar is considered to be a global reserve currency. The U.S Fed had indicated that the rate normalization cycle will begin from March’22. This is majorly due to an increase in the inflation rate.
In this article, we will understand how a hike in the Fed interest rate will impact India.
But before that let us know what Fed Rate is and how it works?
Table Of Contents…
- What Is Fed Rate?
- How is the Federal Fund Rates Determined?
- What is the major difference between Federal Fund Rates and Regural Interest Rates?
- How does the Fed Rate Impact USA?
- How does the Fed Rate Impact The World?
- How will an increase in Fed Rate Impact India?
What is the Fed Rates?
The Fed rate refers to the federal funds rate which is the interest rate at which institutions (depository) like banks & credit unions lend reserve balances to other depository institutions from their reserve balances on an overnight basis. The fed rate is set by the Federal Open Market Committee (FOMC), which is also the policy-making body.
As per the monetary policy, the FOMC (authority) meets eight times a year to decide the target federal funds rate. The fed rate is determined and adjusted to achieve economic growth in the country. Fed rate influences the short-term rates of both consumer loans and credit cards. The fed rate impacts the borrowing cost and financial conditions of a stock market.
The stock market is typically sensitive to change because of the fed rate. The Fed Rate also helps in strengthening the Dollar. You must be wondering how? Below listed are the reasons for it.
- When the committee (FOMC) increases or decreases the Fed fund rates, its action typically impacts the entire economy. This results in the strengthening of the currency i.e. Dollar.
- The higher yield attracts investors and huge capital investment in return for the higher return of bonds and interest rate products.
- An upward and downward trend in the fed funds rate is directly related to the moves in the US dollar exchange vs. other currencies in the world.
How is the Federal Rates Determined?
The Federal Open Market Committee meets eight times a year to set the fed rate. Economic indicators like core inflation rate, recession rate, and other factors that affect economic growth are taken into consideration. The FOMC decides the adjustment in the rate based on these parameters. If you analyze the past the Fed fund rate has been extensively spread. It has been as high as 20% and as low as 0% to 0.25% to accelerate the economy.
What is the major difference between Fed Rates and Regular Interest rates?
The Federal fund rates and regular interest rates both are financial indicators in the United States. Federal funds refer to the rate which is fixed by the FOMC (Federal Open Market Committee) for the banks and financial institutions to lend and borrow from each other overnight. This impacts borrowing cost and also financial conditions, as stock markets are sensitive to these changes
While the interest rate is the rate that is determined by the Federal Reserve. The determined rate is the cost that banks & financial institutions will have to shell to borrow money.
How Does Fed Rates Impact the USA?
An increase in Fed fund rates impacts the whole economy. Below listed are a few of them-
- Federalism affects both the monetary and financial conditions of the economy. Thereby impacting employment, growth, and inflation.
- It also influences short-term interest rates for everything from home to auto loans, as lenders determine the rates based on the lending rate.
- The stock market typically reacts firmly to changes in the target rate. For example- A decline in the interest rate influences the market to take the higher leap as borrowing cost reduces and vice versa.
- Investors keep a watch on the fed fund rate to channel their funds.
- It is one of the most important rates as it determines future activities in the economy.
How will the Fed Rates impact the world?
America is the world’s largest economy and every move in the economy affects the global markets. An increase in interest rates will lead to the appreciation of the currency. Since the US dollar is considered as a benchmark to evaluate current and future economic growth. A stronger Dollar is considered a positive sign in developed countries but it is the opposite when it comes to emerging countries like India.
- Treasury Bonds – An increase/decrease in US interest rates is directly proportional to US treasury bonds. Immediate reflection in the treasury yield curve can be noticed via the domestic interest rates. Since Treasury bonds are considered as risk-free assets other security will need to offer a higher rate to remain attractive.
When the interest rates are increased global investors will want to park their funds in the US. This will impact the emerging markets with a direct effect on the employment levels.
- Dollar Denominated Debt– A hike in the Fed interest rate indicates economic performance. At the same time, emerging markets might suffer. Countries like South Africa, Brazil, Turkey, and others have a trade deficit. These countries generally finance the current deficit by building dollar-denominated debt.
Since the dollar would appreciate, the exchange rate between emerging markets and the US tends to widen. This results in an increase in dollar-denominated debt which becomes unmanageable.
- Credit Market– An increase in the fed rates will make the cost of borrowing more expensive. This would increase the cost of capital and hinder production, consumption, and manufacturing.
The consequence of an increase in the rate will cost the emerging nations. It would accelerate capital outflows from the country and cause financial turbulence. Lending to indebted countries will drop significantly.
- Commodities Market– Various commodities like oil, silver, gold, and others are priced as per US dollar. An increase in dollar price would mean an increase in the price of these commodities. Emerging economies that rely on commodity production and have an abundance of natural resources will be adversely affected.
- Foreign trade– Both the increase and decrease in the fed interest rate will impact the global economy. A stronger dollar will lead to an increase in demand for products around the world. This will result in increased profits for domestic as well as foreign companies. Fluctuations in the stock market sentiments but an increase in profits will spike the stock markets again.
How will an increase in Fed Rates Impact India?
Just like any other emerging market India will also have to face the repercussions. The impact of the Fed rate increase can be understood with the help of points listed below-
Impact on Rupee
- An increase in the fed rate will impact both the availability and cost of overseas finance. The hike would ideally lead to global investors pulling out money from the Indian stock markets (equity and bonds). This would result in a decline in investments from FPI in the Indian government securities. Cash outflow from India would weaken the Rupee as the central bank may raise interest rates to prevent the FPI exit.
A weaker rupee would mean lower returns to foreign investors. Investors with long-term horizons won’t panic with marginal hikes but small investors might back off because of volatility in the market. The weaker rupee requires hedging the position and also cutting short the returns. In a nutshell, a hike in Federal rates will weaken the Indian rupee and impact the economy negatively.
US-based sectors will perform better
- The hike in the fed rate suggests that the US economy is doing well. The recovery is now well entrenched. Few sectors in India such as the Pharmaceutical and IT sectors are dependent on the US for their revenues. A strong dollar would directly lead to an increase in exports of these sectors. Export-driven companies would see a spur in their sales. Since rupee would depreciate inversely leading to an increase in sales. Though one cannot chart a direct relationship between the two, few sectors in India will have a positive impact on their growth.
Effects on the Indian Stock Market
- Before we understand how it will impact the stock market. Let us know why India has now become the first choice for investors? The US is a developed economy that has limited growth possibilities. On the other hand, India is still a growing economy that has massive growth opportunities. Interest rates in the US are relaxed as compared to Indian markets. This means an investor can avail of finance at a lower interest rate from the US, on the other hand, India has a high rate of interest. This significantly reduces the borrowing cost of the investor if he finances his investment from the US.
Now let us take an example to understand the concept.
Mr. Gomes is a foreign investor who borrows 1 lakh US dollars by spending an additional 3% as a borrowing cost. He then invests the same money in the Indian stock market and earns 12% annual returns. Hence Mr. Gomes makes a profit of approximately 9%. If Mr. Gomes had borrowed the same money from the Indian financial market he would have to pay around 7 to 8% as borrowing cost.
So the bottom line of the example is borrowing from the market where interest rates are lower and investing in the market where interest rates are higher leads to an increase in the profit spread.
Now, a hike would mean that the investors would cash out from the Indian stock market as they would be less attractive for them. A rate increase also impacts US Treasuries yield which motivates investors to invest in the USA. Therefore, to sum up, the Indian stock market would receive a setback with an increase in fed rates. Investors would want to invest their money in safe and secure assets & companies. The government will have to revise the policy to make it more lucrative and attractive for the investors to stay back invested in the market.
Reserve Bank of India will regulate interest rate
- With an increase in the Fed rates Reserve Bank of India will look into normalizing the domestic policy. The authority may follow the global cues and increase the interest rate. Though it isn’t very clear from the Reserve Bank of India whether they would increase and when. If there is an upward movement in the domestic interest rate four to six rounds of the hike can be expected. It also depends on inflation. If the inflation in the industry becomes sticky for a long time then a higher increase in the base points can be expected.
Eminent leaders in the country want RBI to be aggressive in reconsidering monetary policy. Historically it has been noticed that when the fed rates are changed it impacts emerging markets like India. Only if there is a major disruption in the equity and currency market RBI is expected to increase the interest rate by April- June quarter. India needs to have its independent policy based on domestic needs hence action from RBI is still not confirmed while one can expect that RBI may intervene when the situation worsens.
Interest rates are fundamental indicators of an economy’s growth. In the US, the FOMC (Federal Open Market Committee) has increased the Fed Interest rate to combat inflation. This would help the US economy to control overproduction. Though it will impact the US economy positively, an increase in the fed rate will impact emerging economies like India.
Higher growth rates, government reform measures, and falling inflation are a few reasons that would help the economy to sail through. If required, the Reserve Bank of India will take appropriate measures to combat its effect on the economy. Since the US is a global leader, repercussions will be felt globally.