US Federal Reserve raises interest rates

On 16 December, the US Federal Reserve has raised the interest rates by 0.25 percentage points, from its previous 0pc to 0.25pc range. It is for the first time in seven years the Fed rate is hiked.

What is Federal Reserve?

The US Federal Reserves was created by the US Congress in 1913 as an independent organisation to study and implement monetary policy. The Federal Reserve is subjected to oversight from Congress but its decisions do not have to be get ratified by the government or the US President.

What is fed rate and its importance?

The federal funds rate or the fed rate is the interest rate that is applicable to the overnight loans between banks and credit institutions. It means the fed rate sets the short-term benchmark in the financial sector. The interest rate hikes over a period of time will guide the long-term rates in the US market and they will affect how much people pay for their loans, how much companies pay for their borrowings, and how much the banks pay for the bank deposits. It will also affect the payments to be made by the foreign companies and governments on their borrowings.

Why the recent rise is so important?

Since December 2008, the Federal Reserve kept the rate near zero to support the economic recovery in the US after the worst financial crisis and recession. Since then the rate was continued to be low as the economic recovery took longer time. The present rate hike signals that the US economy on recovery mood and a ‘normal’ or tighter monetary policy is on cards.

How the rate hike affects the US economy?

Since the rate hike was making news from the start of 2015, the increase itself should not have much impact. Whenever there is a rise in the interest rate, US Dollar will appreciate. The US imports would become cheaper whereas the exports from US will become expensive. What is more important is what the Fed indicates about future rate increases. The Fed’s economic forecasts points to relatively rapid interest rate increase in 2016. That means the dollar could become further stronger and loan and deposit rates could also increase more.

How does the rate hike impact India?

A rate hike could potentially encourage the foreign investors to pull out their investment from India and invest it in the US market as they may get more interest over there. The US Dollar strengthens against other currencies, gold and other asset classes.

The rake hike will increase pressure on Indian rupee though RBI intervenes to arrest the fall. The RBI might use forex reserves to keep the rupee from falling further. The RBI would not cut the interest rate and would rather raise them.

As dollar strengthens, our import bill will increase and might put pressure on current account deficit. Due to increase in import expenditure inflation will rise. As global dollar liquidity will diminish, Indian corporates with external commercial borrowings will likely to face pressure for repayment.

But this time India is better prepared than its peers. First, India’s external balances have significantly improved in recent times and the current account deficit also narrowed. Second, only a small part of India’s sovereign debt is held by foreigners or is denominated in foreign currency. Third, India’s favourable economic growth outlook makes it an attractive destination for the foreign investors. Fourth, compared to its peers, India is less dependent on commodity exports, and has thus not been negatively affected by the global rout in commodity price. When there is a rate hike, the US dollar becomes stronger. As the global commodity priced in dollars, the rate hike will translate to a proportional hike in commodity prices. Then commodity based economies suffer due to slower exports.

Is a rate increase certain?

It is not certain. But many economists believe that the US economy is coming out from the economic crisis and they expect the rate increase. The US labour market showed improvement and it may lead to inflationary pressure necessitating a hike in interest rate.