The US Federal Reserve, the central bank of the US, has increased its short-term policy rate (like the repo rate in India) by 25 basis points. This step is a ‘U’ turn in its monetary policy stance as since the outbreak of Covid, the Federal reserve has been keeping its interest rate low and was pumping money into the economic system. These two step means the central bank was following an easy money policy to support the recovery of the covid hit economy.
Now, such an expansionary policy has to be reversed because of the strong inflation occurrence in recent months in the US. Usually, in an economy like the US, the inflation rate will be around 2%. But the US labour Department indicated that the inflation rate reached a 40 year high of 7.5% in February. The rate may go even higher in the context of the potential supply shock of the Ukraine invasion. So, the inflation hike should be countered.
We all know that the policy medicine to contain inflation is to raise the short-term interest rate (the repo rate for example in India). Hence, the US Fed has declared a plan several months ago to raise the interest rate and thus to reverse the expansionary monetary policy it has followed since the Covid outbreak. Here, the current hike is a beginning of the interest rate hike by the Federal Reserve.
The first phase hike was made by the Fed on March 17th. This is the first interest rate hike since the Covid-19 pandemic hit the global economy. Now, the question is how this rate hike by the US Fed will influence the Indian economy.
Effect of the US Federal Reserve on the Global Economy
The effect of the monetary policy actions of the world’s biggest central on the global economy is widely researched and acknowledged after the Global Financial crisis. The IMF and the RBI explains that the monetary policy of the systemic advanced economies (AEs) like the US will create spillover effect on the economies like India. The IMF says that there is high interconnectedness among the financial markets and the action by one central bank will have significant bearing on other countries as well as on the monetary policy actions of other central banks.
But before analysing the impact of the Fed’s U turn and the rate hike, always understand the way in which the Fed implemented the interest rate hike this time. It has given constant notices, advices and timeline plans for implementing the policy rate hike. Everybody in this world was convinced about the timing of its actions. In other words, financial markets, central bankers of other countries, investors and regulators all have good anticipation or expectation of the current policy rate hike. This informative intervention by the Fed was to avoid any shock in the global economy as a result of its policy actions.
Now, we are analysing the potential effects of the US Fed’s policy rate hike on the Indian economy.
- On the Indian equity market: This is the biggest impact point because India’s financial market liberalisation is peculiar, and is concentrated in the equity market The stock market especially, the equity market is significantly opened to foreign investors. Here, the US investors are sourcing funds from the US markets and are investing in indian shares. But when the US interest rate goes up (as a result of the Fed rate hike), the cost for mobilising funds to make investment in India also goes up. Hence, the response to the global investors including the US investors to a hike is US interest rate is quite predictable. They withdraw their investment from India. For this they sell Indian shares. The continuous selling by the Foreign Portfolio Investors during the past few months indicate that they were making early response to the future increase in US interest rate to be made by the Federal Reserve. This means that the FPIs were anticipating the Fed action and made exit early and hence, there was no sudden stock market sell of as a result of the interest rate hike decision by the Fed. Note that the indian equity market index registered smart rise on March 17th.
- On bond yield: The second market where the US Fed decision is having an impact is the bond market. Here, the government has opened up the bond market – both government and corporate to FPIs. Over the last few months, the bond yield were rising due to constant selling by the FPIs. They were exiting from the indian market anticipating a rise in US interest rate. Hence, a rise in US Fed rate will increase the bond yield in India.
- On exchange rate: the exchange rate of rupee has undergone notable depreciation due to the selling by FPIs. Though the latest decline in the value of rupee was mainly due to the Ukraine invasion, before that the market was adjusting to the sell of by FPIs and their conversion of rupee into dollar and the increasing demand for dollar in the forex market. Still, a steep depreciation was not there because of slow selling of rupee due to the anticipatory nature of the Fed decision.
- On the bank loan market and the banking system: Non-Resident Investors are not allowed to hold significant deposits in indian banks. This is a notable feature of India’s financial market liberalisation. Foreign deposits in indian banks are not welcome. Hence, the US fed rate hike will not have any effect on the banking sector including deposits and loans.
- Monetary Policy of the RBI: the US Fed decision will have significant impact on the RBI’s monetary policy. The accommodative monetary policy stance of flooding funds into the foreign markets due to the low interest rate high money supply policy of the Fed his over. We entered a new financial cycle featured by high interest rate, restricted money supply, high bond yield etc. Besides, the inflation rate in India is soaring up. In the near future, the price rise of crude products will definitely bring up prices and inflation. For that phase, the RBI has to be get prepared and the policy actions have to be made now. At present, the RBI is continuing the low repo rate accommodative policy. Soon, it has to increase the repo rate. Or in other words, the RBI has to follow the footsteps on the US Fed’s rate policy in the April 6-8 monetary policy declaration.