In News
- Recently, the US Federal Reserve hiked interest rates by 0.75 percentage points which is the highest rate hike in 28 years in a bid to tame runaway inflation.
About the United States Federal Reserve
- Central bank: The US is the world’s biggest economy and the Fed is the biggest central bank.
- The role of the Federal Reserve:
- Conducting the US monetary policy to promote maximum employment and stable prices;
- Promoting the stability of the financial system and seeking to minimise and contain systemic risks through active monitoring and engagement in America and overseas;
- Promoting the safety and soundness of individual financial institutions and monitoring their impact on the financial system as a whole;
- Fostering safety and efficiency in the payment and settlement system through services to banks and the federal government that facilitate US-dollar transactions and payments;
- Promoting consumer protection and community development through consumer-focused supervision and examination, research and analysis of emerging consumer issues and trends, and the administration of consumer laws and regulations.
- Monetary policy: The Federal Reserve controls the three tools of monetary policy:
- Open market operations
- Discount rate
- Reserve requirements.
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Reason for the hike
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Impact on the global market and their economy
- Reverse the expansionary monetary policy: The new projections are being seen as a move to reverse the central bank’s expansionary monetary policy put in place in early 2020 to invigorate the American economy amid the Covid-19 outbreak.
- This step is intended to bring down long-term interest rates and catalyse greater borrowing and spending by both consumers and businesses.
- When interest rates go up in an economy: it becomes more expensive to borrow, so households are less inclined to buy goods and services, and businesses have a disincentive to borrow funds to expand, buy equipment or to invest in new projects.
- A subsequent lowering of demand for goods and services ends up depressing wages and other costs, in turn bringing runaway inflation under control.
- A high rate signal by the Fed would also mean a lower impetus to growth in the US: which could be yet negative news for global growth, especially when China is reeling under the impact of a real estate crisis.
- Currency markets: There is also a potential impact on currency markets, stemming from outflows of funds.
India specific impacts
- Foreign Portfolio Investors: Emerging economies such as India tend to have higher inflation and, therefore, higher interest rates than in developed countries.
- Thus, investors including Foreign Portfolio Investors tend to borrow in the US at lower interest rates in dollar terms, and invest that money in the bonds of countries such as India in rupee terms to earn a higher rate of interest.
- Currency carry trade: When the Fed raises its policy rates, the difference between the interest rates of the two countries narrows, thus making countries such as India less attractive for the currency carry trade.
- RBI’s monetary policy: The Fed’s decision to hike rates will also have a bearing on the Reserve Bank of India’s monetary policy.
- Pressure on the rupee: In the Indian economy, the rate hike could further weaken the domestic currency which has depreciated already.
- Imported inflation: As India is a big importer of gold, crude and electronics, the rising cost of imports is likely to further widen the current account deficit (CAD).
Major Concerns/ Challenges
- War and COVID: Prices have spiked partly due to external factors that include the war in Ukraine and the continuing Covid-19 shutdowns in China’s key manufacturing hubs.
- Price of gas and groceries: Fed’s rate hike can make borrowing costs more expensive and bring down demand in the economy by forcing consumers and businesses to curb spending.
- However, it has no control over supply shocks, which are currently being caused by the ongoing Russia-Ukraine war.
- Gold prices may soar: gold prices could be on the rise as more people look to diversify their money and not park their money in bank deposits.
- Cost of borrowing: When the Fed raises the target interest rate, the cost of borrowing increases.
- Job cuts: rising rates will also spark a period of slower economic growth, which could result in layoffs.
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Hike by other central Banks
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Way Forward/ Suggestions
- Quantitative easing: The bond buying programme also known as quantitative easing was put in place in 2020 as an extraordinary measure to help the financial markets and the economy counter the impact of the pandemic.
- Here, the central bank purchases longer-term securities from the open market in order to increase the money supply and incentivise lending and investment.
- The Fed halted the process of putting the proceeds of an initial $15 billion of maturing Treasuries back into the American government debt market.
Source: IE