The Federal Reserve System, commonly known as the Fed, plays a pivotal role in shaping US monetary policy. Recently, the Fed implemented a substantial increase of 0.75 percentage points in its interest rates to curb escalating inflation, marking the most significant rate hike since 1994.

Federal Interest Rate:

  • The federal interest rate is the average rate that banks pay for short-term borrowing in the federal funds market.
  • It serves as a reference for various interest rates within the US economy and significantly influences the value of the US dollar and the broader financial market.
  • The federal interest rate is a critical determinant of global economic dynamics due to its impact on asset prices and international capital flows.

Impact on India:

  • A surge in the US interest rates allures investors toward safer assets, such as US bonds, instead of riskier emerging markets like India.

This shift leads to several repercussions for the Indian economy:

Trade Implications: Imported Inflation: With increased US rates, the cost of oil imports for India rises, potentially driving domestic inflation upwards.

Current Account Deficit (CAD): Escalating import costs could widen India’s CAD as a result of increased expenditure on imports.

Foreign Portfolio Flows:

  • The global “carry trade” phenomenon, where investors borrow in low-interest rate currencies to invest in higher-yielding assets, could reverse due to rising US rates.
  •  This could lead to a sell-off in global markets, including India, which would impact foreign portfolio flows and decrease India’s foreign exchange reserves.

Exchange Rates and Rupee Value:

  • Strengthening of the US dollar due to higher interest rates may lead to a decline in the value of the Indian Rupee.
  • Heightened global risk aversion can prompt the shift of investments from emerging markets, including India, to safer assets like gold and US treasury instruments.

Effect on Indian Companies: The increased cost of overseas finance due to higher US interest rates can impact the availability and cost of funds for Indian companies.

Global Growth Concerns: The US rate hike might hamper global growth prospects, especially when China is grappling with a real estate crisis.

Rise in Gold Prices: As investors seek diversification from bank deposits, gold prices could soar.

Tools India has adopted:
To counter the adverse impacts of global factors, India has implemented various measures:

  • Enhancing Attractiveness of Debt Instruments: Expanded foreign investment access to Indian debt instruments, including all government securities, and relaxed short-term investment limits.
  • Strengthening the Rupee: Temporarily removed Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), and interest rate caps on foreign currency deposits to boost NRI investments and support the Indian Rupee.
  • Boosting Foreign Exchange Inflows: Doubled borrowing limits for overseas companies to $1.5 billion annually.
  • Facilitating Foreign Currency Borrowings: Permitted banks to undertake overseas foreign currency borrowing up to a limit of 100% of unimpaired Tier 1 capital or $10 million.
  • Managing Current Account Gap: Raised import duties on gold and increased levies on petroleum products to control current account imbalances.

In the face of the US Fed’s interest rate actions, India’s economic management requires a delicate balance of policies. While the influence of the Fed is undeniable, the mitigating measures taken by India, such as enhancing debt instrument attractiveness and supporting the Rupee, demonstrate the nation’s commitment to safeguarding its economic stability. The Reserve Bank of India’s response will be crucial in maintaining an equilibrium between domestic priorities and global monetary dynamics.

Legacy Editor Changed status to publish March 21, 2024