Home / Economy / Explained: How Fed’s rate hike will affect India

Last Wednesday, the US Federal Reserve increased the federal funds rate, its key short term interest rate, by 75 basis points to 3-3.25%. Federal funds rate is the interest rate at which commercial banks in the US lend their excess reserves to each other on an overnight basis. One basis point is one-hundredth of a percentage.

The Fed sets the federal funds rate in order to try and influence the short-term interest rates in the economy. This decision of the Fed is widely watched as it has repercussions all across the world. In this piece, we will try and understand these implications.

How big is this hike?

This is the third time that the Fed has hiked the federal funds rate by 75 basis points this year. It now stands at 3-3.25%, the highest it has been since January 2008, when the rate had stood at 3.5%. Hence, this is the highest the rate has been in nearly 14 years.

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Why is the Fed raising rates?

Retail inflation in the US has been at multi-decade highs. Inflation is the rate of price rise. In August, the retail inflation had stood at 8.3%, lower than the 9.1% inflation experienced in June— nonetheless, still at a very high-level. The idea is to raise interest rates, dampen consumer demand, and in the process, slow down inflation.

Will targeting only short-term interest-rates help?

In reality, the Fed is also targeting long-term interest rates. In the aftermath of the financial crisis that broke out in September 2008 as well as slightly before the covid pandemic started, the Fed printed and pumped a lot of money into the financial system. The idea was to drive down long-term interest rates in the hope that people would borrow and spend more and companies would borrow and expand, leading to a pickup in economic activity. Now, the Fed is planning to gradually take out this money. The plan is take out $95 billion in September, and continue with it in the months to come. With lesser money expected to go around in the financial system, the long-term interest rates on everything from home loans to loans given to businesses, have been rising.

How do higher interest rates help control inflation?

Let’s consider the following example. At lower interest rates, the EMIs people need to pay in order to repay a loan are lower. Take the case of home loans. As interest rates fell in 2020, home loan disbursals went up. In the process, home prices went up as well. In the three-month period ending June, the median sales price of houses sold in the US rose by 15.1% to $440,300, in comparison to the same period in 2021. In fact, in the period of three months ending September 2021, the prices had risen by 22% to $411,200. The price rise in cities was considerably more.

When home prices go up, new home building picks up as well. This pushes up prices of everything that goes into the making of a house and furnishing it. This feeds into retail inflation. When interest rates are raised, the EMIs go up and the hope is that demand for homes will come down. This does not happen immediately and takes time. As the demand falls, so does inflation. The total number of building permits issued in August was 14.4% lower than in August 2021. As Jerome Powell, the chairman of the US Fed put it: “Activity in the housing sector has weakened significantly, in large part reflecting higher mortgage [home loan] rates."

But wasn’t inflation due to supply side issues?

Yes, that is true. Supply chains broke down as covid spread and that sent the prices of goods soaring. The supply chains have been restored to some extent. Also, the war in Ukraine sent the prices of oil and other commodities soaring. Nonetheless, at the same time, thanks to low interest rates, consumer demand has grown at a fast pace. Take the case of consumer credit. It grew by 7.7% in July, the fastest since November 2011. This clearly is an impact of low-interest rates feeding into consumer demand which leads to higher inflation.

Are there any other side effects of low interest rates?

As we have seen earlier, home prices have gone up because of low interest rates. This has also led to home-rents going up at a fast pace because everyone cannot afford to buy homes. In August, the average rent for a primary residence in cities in the US rose by 6.7%. While this might not sound very high to Indian ears, it’s the highest since November 1982. So, in August, home-rents rose at a pace which was almost a four-decade high. Home rents are an important part of the index of items that are used to calculate retail inflation. Hence, higher home rents lead to higher inflation. The only way the Fed can control this is to raise interest rates and, in the process, slow down the rate of rise in housing prices and thus home-rents.

As Powell put it: “We’ve had a time of a red-hot housing market, all over the country, where famously houses were selling to the first buyer at 10% above the ask, before even seeing the house… So, there was a big imbalance between supply and demand and housing prices were going up at an unsustainably fast level."

Won’t raising interest rates slow down the economy?

Yes, and the Fed, unlike earlier, is now saying precisely that. The Fed plans to increase the federal funds rate to 4.25-4.5% by the end of this year, higher than 3.25-3.5% projected in June. Powell said: “I think that there’s a very high likelihood that we’ll have a period… [of] much lower growth... So the median forecast now I think this year among my colleagues and me, was 0.2% growth. So that’s very slow growth." An economic slowdown in the US will impact countries all across the world given that the size of the US economy is still a little under a fourth of the size of the global economy.

And what about unemployment in the US?

The unemployment rate in the US is at a 50-year low with the vacancies being almost twice the number of unemployed people. As Powell put it: “The labour market continues to be out of balance, with demand for workers substantially exceeding the supply of available workers." This has led to huge wage inflation. The wage inflation in July stood at 9.1%. This was lower than the wage inflation of 9.4% seen in March, 9.3% in May and 9.8% seen in June. Nonetheless, this kind of wage inflation was last seen in late 1981. When people expect inflation to be higher, they demand higher wages in order to be able to deal with higher prices. This leads to higher wages, which in turn leads to higher inflation.

How will this inflationary cycle be broken?

This cycle needs to be broken and it can only be done so by dampening consumer demand to some extent. This can be done by raising interest rates, leading to businesses looking to employ fewer people. In fact, as Powell put it, in as euphemistic a way as possible: “We think we need to have softer labour market conditions as well." This essentially means that demand for employees needs to fall and unemployment needs to go up to some extent. Powell went on to add: “We’re never going to say that [there] are too many people working, but the real point is this, inflation, what we hear from people when we meet with them is that they really are suffering from inflation. And… we have got to get inflation behind us. I wish there were a painless way to do that, there isn’t."

So, how will this impact the world at large?

As interest rates in the US go up, the likelihood of money moving from other parts of the world to the US goes up, given that the US dollar is deemed to be the safest currency in the world. In order to slowdown this process, central banks of other countries will have to increase their respective interest rates as well. The Riksbank, the Swedish central bank, pre-empted the rate increase by the Fed, by increasing its interest rate by 100 basis points on 20 September. The Bank of England, the British central bank, followed the Fed by raising its interest rate by 50 basis points on 22 September. The expectations are that the European Central Bank will also raise rates when it meets next on 23 October and so will the Reserve Bank of India on 30 September. In all this, on 22 September, the Bank of Japan decided to maintain the interest rate level, despite inflation hitting a nearly 8-year high of 2.8%. The increase in interest rate is also expected to tackle decadal high inflation across the rich-world. At the same time, high interest rates will slow down the respective economies.

How will this impact India?

As mentioned earlier, with interest rates in the US going up, the likelihood of money moving out from countries and going to the US goes up. The prospect of this happening has an impact on the exchange rate of currencies against the dollar. The Indian rupee has been losing value against the dollar since early 2022. On Thursday, the value of the dollar crossed 80 for the first time and closed at 80.87. On Friday, it closed at 80.99. A weaker rupee should help Indian exporters at some-level. Nonetheless, the chances of a recession in the rich world, including the US, have gone up and that will hurt them more. This includes the Indian information technology (IT) companies. Of course, stock prices don’t wait for events to happen, they discount for possibilities. The NSE IT Index, which consists of ten companies, has fallen by 31.3% year to date.

What about Indian stocks as a whole?

On Friday, the BSE Sensex, India’s premier stock market index, fell by around 1,021 points or 1.7% to close at 58,099 points. This was the immediate impact of the Fed raising interest rates, with the foreign institutional investors net selling stocks over the last two trading sessions on Thursday and Friday. Nonetheless, over the last few months, the story being sold is that the Indian stocks have decoupled from what is happening globally. This theory is backed by some data. In the last one year, the BSE Sensex has fallen just 3.3%. In comparison, the Dow Jones Industrial Average, America’s premier stock market index, has fallen 15%.

Of course, the question is whether this decoupling will continue and whether the Indian stocks will continue to do better than their global counterparts. While fund managers and others who make money out of you and I buying and selling stocks, indirectly and directly, would like us to believe that the Indian stock market will do better than other stock markets in the time to come, there is no real way of knowing this for sure. Also, if the Fed keeps raising interest rates as it has said it will, the chances of a sustained sell-off by foreign investors go up. Of course, domestic investors and corporates slush with profits can keep propping up the market, as they have in the last one year.

Who else will get impacted?

The venture-capitalist unicorn/startup ecosystem is already getting negatively impacted by the rise in interest rates. The faster the interest rates rise, the more you will hear venture capitalists and unicorn managers talk about the importance of profitability and the need for their business to become profitable sooner. At the same time, the crazy valuations in the startup eco-system are bound to fall. Of course, that will take time, given that there will be a lot of resistance from the eco-system.

Vivek Kaul is an economic commentator and a writer.

Elsewhere in Mint

In Opinion, Manu Joseph writes about the power of the second rung of the elite. Nitin Pai argues why liberals have strong reasons to be conservative. Amit Kapoor & Bibek Debroy write why India’s success matters to the world. Long Story explains how the world grapples with the US Fed rate hikes.

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