Federal Reserve's interest rate hike signal and Indian markets

US Federal Reserve interest rate policy, and the Indian markets - an update

Federal Reserve's interest rate hike signal and Indian markets

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• The story: Rate hikes by the Federal Reserve of USA (the central bank of USA) affect not only the US economy, but also shape the macroeconomic outlook overall, and exert a certain degree of influence on the monetary policies in other emerging economies. This is so because investors would rather move money into American treasuries (risk free) than stay put in emerging market assets.
• US Federal Reserve: This institution was created on December 23, 1913, with the enactment of the Federal Reserve Act. The U.S. Congress established three key objectives for monetary policy in the Federal Reserve Act: maximizing employment, stabilizing prices, and moderating long-term interest rates. The Federal Reserve System is composed of several layers. It is governed by the presidentially appointed board of governors or Federal Reserve Board (FRB). Twelve regional Federal Reserve Banks, located in cities throughout the nation, regulate and oversee privately owned commercial banks. Compared to the RBI, we observe that "maximising employment" or "generating growth" has traditionally not been the mandate.
• Link of US Federal Reserve and Indian markets: Emerging economies (like India) tend to have higher inflation and higher interest rates than those in developed countries. Financial institutions (like Foreign Institutional Investors (FIIs)) borrow money in the US at low interest rates and invest that it in government bonds of emerging countries to earn a higher rate of interest. When the US Federal raises its domestic interest rates, the difference between the interest rates of the two countries decreases. This makes India less attractive, and some of the money may move out of the Indian markets and flow back to the US. This impacts not just the equity and debt markets, but also India’s currency against the US dollar. INR may weaken in case large outflows happen.
• Effect of raised interest rates on India: India being one of the largest crude oil importers of the world, a weaker rupee compared to dollar results in more expensive imports of crude oil. Expensive crude oil naturally pushes the overall inflation in economy.

1. Bond yields would also tend to rise due to growing dollar shortage in the global market. Earlier the debt and equity markets witnessed outflows of over Rs 40,000 crore rupees, due to the strengthening dollar. Bond yield is the amount of return an investor will realize on a bond, calculated by dividing its face value by the amount of interest it pays.
2. India’s IT and IT-enabled services export will benefit but the same benefit may not fully accrue to exporters due to strong competition in the export market.
3. An associated idea - in addition to rising interest rates - is that of reducing liquidity operations in US market. That is called "taper" of the Quantitative Easing project. The effect of that is called "taper tantrum".

• Summary: While in 2013, the "taper tantrum" created a huge problem for Indian economy, this time round in 2022, India overall may be in a better position to deal with higher global interest rates. Multiple tailwinds (positive push) from improving corporate and bank balance sheets, recovery in residential real estate, a boost from global trade and exports and the availability of global capital, all suggest that India’s GDP growth can recover and grow at a faster pace than pre-pandemic. A lot will depend on the budget as well.
• EXAM QUESTIONS: (1) How would the higher global interest rates effect macroeconomic stability of India? Analyse. (2) Explain the importance of foreign investment in an economy like India. Why is it dependent on foreign money? (3) Why should India bother about what the US Federal Reserve does locally? Explain.

#USfederalreserve #monetarypolicy #interestrate #tapertantrum

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