Explainer: Why the US Fed’s  policy  move matters to India?

What is the relevance of US Federal Reserve?

The Federal Reserve (Fed) is the US central banking system and comprises a board of governors, 12 regional federal reserve banks, and the Federal Open Market Committee (FOMC). Its key functions include banking system regulation, managing money supply, implementing monetary policy measures, stabilizing price levels and maximizing employment. The monetary policymaking body FOMC is constituted by the board of governors and five federal reserve bank presidents on a rotating basis, and meets eight times in a year to deliberate and decide on monetary policy and interest rates.

Why is a change in Fed rates a concern for all?

Since the US is the world’s largest economy, any interest rate changes there influence exchange rates, international money flows and, to a certain extent, interest rates the world over. When the FOMC raises rates, foreign institutional investors (FIIs) of American origin and other large foreign funds in search of better returns move back to the US, which offers effectively higher interest rates. When FIIs withdraw money from the host country, it negatively influences the exchange rate, thereby depreciating the host country’s currency and resulting in appreciation of dollar.

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What has been the trend in rates over the past decade?

In December 2007, the Fed funds rate stood at a steep 4.25%, which was brought down to 0-0.25% in the wake of the global financial crisis. With US GDP growth improving to 3.1% in 2015, rate hikes followed, and the fed funds rate peaked at 2.25-2.5% in December 2018. The rate began falling again in August 2019, once again nearing 0-0.25% in March 2020.

What is its link with the Indian economy?

Given that India is a growing economy offering higher returns, there exists a strong link between changes in Fed rate and FII flows. A Fed rate change leads to fluctua-tions in Indian capital markets and impacts exchange rate. With the FOMC hinting at two rate hikes by 2023, Indian stocks and currency have been adversely impacted. Rupee depreciation can lead to higher import prices, and with crude oil being the largest component of Indian imports, it could lead to increased fuel prices, worsening the cost-push inflation.

What steps can the government take?

Higher rates in the US could hit Indian stocks badly, weaken the rupee and raise the landed price of crude oil. This could result in inflationary pressure, close to the next general elections. Thus, the government should strive for economic revival and initiate reforms, and build on India’s story of being an attractive destination for investors. However, whether it would bite the bullet so close to elections is a point worth thinking about.

Jagadish Shettigar and Pooja Misra are faculty members at BIMTECH.