The Federal Reserve is expected to increase interest rates Wednesday by a quarter-point, at the same time it is also facing a tough task of reassuring the markets. Markets have been whipsawed in the last month by the fear of contagion in the banking system.
The central bank is contemplating using its interest rate tools at the same time it is trying to sooth markets and stop future bank runs. Market has cooled down a bit post UBS weekend agreement to buy Credit Suisse for $3.2 billion as it has soothed some nerves about the global banking system. The biggest question right now is that will the Fed back up its inflation-fighting move and raise interest rates again despite the aftershocks of SVB collapse or it will prioritize financial stability in the banking system?
What Is Expected This Time?
Analysts mostly expect the Fed will increase its fed funds target rate range to 4.7 per cent to 5 per cent, though some expect the central bank could pause its hiking due to concerns about the banking system.
A lot of analysts expect the Fed to make an even bigger rate move until a series of high-profile bank closures and government rescues raised concerns about both the economic outlook and financial stability.
Expectation related to Fed rate hikes also moved dramatically. Specially post the sudden collapse of Silicon Valley Bank that stunned the markets, sending bond yields lower. What was expected to be a half-point hike two weeks ago is now up for debate at a quarter-point or even zero.
In addition to announcing a rate decision, Fed officials will also release a set of quarterly economic projections that will indicate how high they expect borrowing costs too climb this year.
Why Is The US Fed Hiking Interest Rate?
When the US Federal Reserve raises interest rate, the goal is to increase the cost of credit throughout the economy. In simple term, higher interest rate makes loan more expensive for all, be it businesses or consumers, and eventually everyone ends up spending more on interest payments.
This impact how much commercial banks charge each other for short-term loans. A higher rate means more expensive borrowing costs, which can reduce demand among banks and other financial institutions to borrow money, as per the Forbes report.
It is a way to promote people to save money to earn higher interest payments. This eventually reduces the supply of money circulation, which trends to lower inflation and moderate economic activity.
Key Pointers Which Prompts Rate Hike
The banking stress has eased, inflation have been very strong, a significant pause could signal that the Fed is worried about the turmoil in the banking system, and the European Central Bank raised rates sharply last week, these four factors are driving pointers towards a rate hike.
In past few weeks, the Fed pumped up its program that keeps dollar financing flowing around the world, its move to keep up the financial system. It has also unveiled an emergency lending program meant to serve as a relief valve for banks that need to raise cash.
What Does It Mean For The Indian Economy?
After a rate hike by the US Fed, the difference between interest rates in US and India shrinks which affects the currency trade negatively. This starts a chain reaction, US rate hike leads to increase in interest rates in India. So when the US Fed increases rates, RBI also has to increase interest rates here in India so that the outflows of funds from the FIIs (Foreign Institutional Investors) can be curtailed to save guard the rupee. Simply put, the hike will widen the gap in interest rates between the two countries.
Therefore, the foreign investors will be tempted to withdraw from the Indian market and invest in the US assets, as the Dollar and the US Treasury yield become more attractive in the US and the Indian market begins to see capital outflow.
This makes the rupee weaker and it prompts RBI for a rate hike in India. If the rupee falls significantly, the RBI may be forced to sell some dollars to help shore up the domestic currency. This depletes domestic Forex reserve.
We have seen the banking industry getting benefited by the interest rates rise, as banks re-price their loan portfolio much quicker than their deposit rates, which helps them in increasing their net interest margin. On the other side, higher interest rates are negative for real estate sector as the EMIs of the prospective buyer increases, which will dampen demand.
Not all US Fed rate hikes are going to impact India directly, but in the present fragile banking system it is important to keep tabs on the monetary policy changes.
