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US FED RATE

29th September, 2022

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PERSPECTIVE: US FED RATE

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Context

  • Intensifying its fight against high inflation, the United States Federal Reserve has raised its key interest rate by substantial three-quarters of a point for a third straight time.
  • It has boosted its benchmark short-term rate, which affects many consumer and business loans, to a range of 3 per cent to 3.25 per cent, the highest level since early 2008.
  • It also signalled more significant increases in new projections showing its policy rate rising to 4.40% by the end of 2022 before topping out at 4.60% to battle continued strong inflation
  • Around 75 central banks including India’s Reserve Bank of India (RBI) have lifted their benchmark interest rates in the past year, increasing the price of credit across the world.

About US Fed

  • The Federal Reserve System is the central bank of the United States. It performs five general functions to promote the effective operation of the U.S. economy and, more generally, the public interest. The Federal Reserve
    • conducts the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy;
    • promotes the stability of the financial system and seeks to minimize and contain systemic risks through active monitoring and engagement in the U.S. and abroad;
    • promotes the safety and soundness of individual financial institutions and monitors their impact on the financial system as a whole;
    • fosters payment and settlement system safety and efficiency through services to the banking industry and the U.S. government that facilitate U.S.-dollar transactions and payments; and
    • promotes consumer protection and community development through consumer-focused supervision and examination, research and analysis of emerging consumer issues and trends, community economic development activities, and the administration of consumer laws and regulations.

 

The rate hikes by central banks across the world are not a new phenomenon. It is rather used regularly to either increase or decrease inflation. However, the concern here is the recent rate hike is at the highest level since early 2008 and it will even continue this path in the coming months.

What could be the possible impact of such extreme measures?

  • Around 50% of the central banks across the world have gone in 75 basis point increase. This indicates that the economies around the world are returning from the days of ease in liquidity and low-interest rates. Higher inflation (double-digit inflation) is the major reason that explains the increase in interest rates.
  • The increase by US Fed Reserve will not just impact the US market but also emerging economies in particular and global equity & debt markets in general.
  • Foreign stock markets like NASDAQ and Dow Jones have shown stability in the equity market, but as US Fed is going to bring down its rate of inflation from 8.3% to 2% in an aggressive manner will reduce wages, increase unemployment and there could be hard times for the US economy.
  • The central banks around the world adopted ease in liquidity during the times of COVID-19. Hence, it was expected by the economists that globally there will be a phase of slowdown or even recession.
  • If one looks at the individual economy, for instance, the United Kingdom stands to borrow around £100 million by 2023. This will add inflationary pressure and will further aggravate the economic crisis.

Due to collaborative efforts of the government and the Reserve Bank of India (RBI), India can control its inflation, fiscal deficit and current account deficit. However, the increase in global benchmark rates will increase the stress on investments in an emerging economy like India.

How this will impact India?

  • As far as India is concerned, there are several ways in which it will impact:
    • With the US increasing its rate and coming closer to the Indian rate, the arbitrage which Foreign Portfolio Investors (FPI) were getting especially after borrowing from the US and investing in the Indian stock market, will now be not as attractive as before.
    • This will ensure that there would be an outflow of foreign currency from India and the investors will invest in US equities and US Federal Securities.
    • Such outflow of currency or funds will further increase pressure on the currency The Indian rupee had already gone above Rs. 80 to one dollar.
    • However, there will be a cushion for India as it is not globally integrated with the world market. Hence, the Indian stock market will witness a downturn but it will not be very drastic.
    • On the domestic front, the recession or slowdown in the global economy will also mean a lowering and reduction in commodity prices, particularly crude oil.
    • However, the equity markets in the country will go through a prolonged phase of volatility which will have nothing to do with the fundamentals of the corporate sector and also because India is dependent on the foreign flow of money which is assumed to go out.
    • The import of capital goods will be under stress for India and will thus increase pressure on investments and there will be a restrictive investment in software and digital technologies, particularly Startups.
    • The corporate sector, the remittances and the tourism sector will also be under stress as they are dependent on the global economy.

Why the impact will be higher in emerging economies?

  • As compared to 2008, the lending from US central bank has been eight times i.e., $8 million. This explains the higher inflation in not just the US but also European economies which are experiencing double-digit inflation.
  • The world is on the brink of recession and there will be spill-over effects on the economies around the world.
  • Developed world with higher living standards will be able to absorb this and will eventually bring down inflation. On the contrary, developing and emerging economies like India with low per capita income would not be able to absorb such inflationary shocks and will be impacted negatively in the fields of growth, employment, exports, etc.

The spill-over takes place through different channels like trade, commodity prices, sentiments as well as capital flows. When it comes to commodity prices, one does not know how they're going to play out in different countries, with different demands. When it comes to sentiments globally, there's going to be a recessionary trend. So overall, the recessionary trend in most advanced countries of the world means nearly 60% of GDP is under the recessional trend.

How to mitigate the spill-over effect both domestically as well as globally?

  • On the global front, once the war is over, the high prices will be under control. Hence, the advanced countries should slow down the aggressiveness in controlling inflation.
    • The advanced countries will even have to extend a hand to help emerging countries to mitigate such a slowdown or recession.
    • It is time for multilateral institutions like the World Bank and the International Monetary Fund (IMF) to bring all the countries together to revive global economic growth by maintaining the level of employment in majorly advanced countries.
    • The geopolitics has impacted economies, which resulted in a slowdown or recession. This means the ammunition and defence industry globally has to play a responsible role.
  • On the domestic front, India may have to extend the food assistance program adopted during the period of COVID-19.
    • The Reserve Bank of India (RBI) though will have to increase benchmark rates and be more accommodating and kinder when it comes to the balance sheets of commercial banks and non-banking finance companies (NBFC).
    • Where the bank managers should adopt a more careful approach in extending to the corporate as well as the export sector.

There are tough times ahead, a cautious approach is needed and that is what seemingly is evident in the moves made by central banks across the world, specifically, US Federal Reserve which has once again raised the interest rates. As far as emerging economies or developing countries like India are concerned there is likely to be a spillover effect, but there are mitigating steps which can be taken to absorb that impact and move ahead.

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