Economy Updates - Nov-2015

Impact of Fed Rate Hike

  • It is the Central Bank of USA which is considered as the most powerful banking institution in the world. The Fedral Reserve Bank was founded by the U.S.Congress in 1913 to provide the nation with a safe, flexible and stable monetary and financial system.

What is Fed Rate ?

  • The Federal Funds Rate commonly known as ‘Fed Rate’ is “the interest rate” at which depository institutions (banks and credit unions) actively trade balances held at the Federal Reserve.
  • The sub-prime crisis in 2007 and 2008 forced the American Central Bank to reduce interest rate sharply. The Fed brought down the federal fund rate from 5.25 percent in August 2007 to a target rate between 0 and 0.25 percent by December 2008. Since, then there is no change in the interest rate.

Reason for Fed Rate Hike

  • Easy monetary conditions cannot exist indefinitely. The reasons for lowering fed ratewere to pump liquidity in the market during the sub-prime crisis, reduce unemployment rate and bring down inflation.
  • It is expected that Federal Reserve will hike interest rates. It would be an indicator that Fed thinks that the economy of USA is doing well and is expected to be that way. Something like a Doctor’s decision that a patient is well enough to be gradually taken off medication.
  • The Federal Open Market Committee who determines the course of monetary policyhad laid down certain conditions before these measures were reserved such as the long-term unemployment rate declining below 5.2 percent and inflation staying at 2 percent. With the unemployment rate moving close to 5.4 in June, the Fed now appears reasonably comfortable to begin raising rates.

Impact of Fed Reserve on Indian Economy

  • Hike in Fed Rate means that a person saving in USD will be able to gain higher return. Thus, the FII and other similar consortiums would likely take the money away from emerging economies and would park in USA. If one draws similar analogy it can be said that if RBI increases FD rates we would prefer to park our money in Bank FD and takes the money out of Stock Market, Gold, etc. which are presumably risky investments. Thus, similarly, the FIIs, will also take their investments etc from India or other emerging economies which are potentially risky in comparison to USAs economy.
  • This sudden outflow of USD from Indian Market would send markets into correction. Since 2008 the Fed Rates are not hiked and now with this probable hike since the global economy will see bit of shortage of USD. Accordingly it is expected that the USD will become strong in comparison to other currencies. This will put pressure on INR. The exporters will enjoy the higher rate but imports will become dearer. As far as India is concerned the Import has been its thorn in the flesh. Thus, hike in Fed Rate would add to the already increasing fiscal deficit.

Why would the US Fed rate hike impact emerging markets?

  • A large part of the rally that we have seen in emerging markets, including India, was largely contributed by an increase in global liquidity, popularly known as ‘hot money’. Emerging markets are considered vulnerable to monetary policy tightening in the US because a stronger dollar is likely to deter FIIs from making fresh investments. A signal of rate increase by the US Fed will be negative for the markets as it will signal that the era of easy money is largely over, at least in the near term.

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