The Federal Reserve interest hike of 75 bps could trigger a churn in equity markets, cool off investor enthusiasm and further weaken the Indian currency against the Greenback
The US Federal Reserve intensified its fight against high inflation on Wednesday, raising its key interest rate by three-quarters of a point — the largest bump since 1994 — and signalling more rate hikes ahead as it tries to cool off the US economy without causing a recession.
The unusually large rate hike came after data released Friday showed US inflation rose last month to a four-decade high of 8.6 per cent — a surprise jump that made financial markets uneasy about how the Fed would respond.
The Fed’s benchmark short-term rate, which affects many consumer and business loans, will now be pegged to a range of 1.5 per cent to 1.75 per cent — and Fed policymakers forecast a doubling of that range by year’s end.
“We thought strong action was warranted at this meeting, and we delivered that,” Fed Chair Jerome Powell said at a news conference in which he stressed the central bank’s commitment to do what it takes to bring inflation down to the Fed’s target rate of two per cent.
Getting to that point, he said, might result in a slightly higher unemployment rate as economic growth slows.
Let’s take a closer look at what that means, why it is doing so and its impact on India:
What is the impact in the US?
As per Mint, it is doing so to reduce the amount of money available for purchase. As a result, money becomes more expensive to obtain. Financial companies’ short-term borrowing rates will rise. This will have a knock-on effect on almost all other borrowing prices for businesses and consumers.
As bills become more expensive, households will have less spare income when their bills become more expensive. Businesses’ sales and earnings fall when consumers have less discretionary spending money.
Buying a hose or a car, or buying things with a credit card will become more taxing. In short, paying any sort of debt will become more expensive. Also, savings accounts will be affected by higher interest rates. When the interest rates are raised, banks respond by boosting the amount you earn on your deposit accounts.
Higher interest rates on the market might be detrimental to the stock market. For public companies, higher costs and fewer business could result in decreased revenues and earnings, thus affecting their growth rate and stock values.
Existing bond prices will plummet instantly. Existing bonds will lose value as a result of the higher overall rates, making their lower interest rate payments more tempting to investors.
Why is the Fed doing this?
Inflation, inflation, inflation.
Powell said it was imperative to go bigger than the half-point increase the Fed had earlier signalled because inflation was running hotter than anticipated — causing particular hardship on low-income Americans. Another concern is that the public is increasingly expecting higher inflation in the future, which can become a self-fulfilling prophecy by accelerating spending among consumers seeking to avoid rising prices for certain goods.
The central bank revised its policy statement to acknowledge that its efforts to quell inflation won’t be painless, removing previous language that had said Fed officials expect “the labour market to remain strong.”
“It’s going to be a far bumpier ride to get inflation down than what they had anticipated previously,” said Matthew Luzzetti, chief US economist at Deutsche Bank.
Fed officials forecast unemployment ticking up this year and next, reaching 4.1 per cent in 2024 — a level that some economists said would risk a recession.
Yet Powell largely stuck to his previous reassurances that — with unemployment near a five-decade low, wages rising, and consumers’ finances mostly solid — the economy can withstand higher interest rates and avoid a recession.
“We’re not trying to induce a recession now,” he said. “Let’s be clear about that. We’re trying to achieve 2 per cent inflation.”
Powell said that another three-quarter-point hike is possible at the Fed’s next meeting in late July if inflation pressures remain high, although he said such increases would not be common.
Some financial analysts suggested Powell struck the right balance to reassure markets, which rallied on Wednesday. “He hit it hard that ‘we want to get inflation down’ but also hit hard that ‘we want a soft landing,’ ” said Robert Tipp, chief investment strategist at PGIM Fixed Income.
Still, the Fed’s action on Wednesday was an acknowledgment that it’s struggling to curb the pace and persistence of inflation, which is being fueled by a strong consumer spending, pandemic-related supply disruptions and soaring energy prices that have been aggravated by Russia’s invasion of Ukraine.
Inflation has shot to the top of voter concerns in the months before Congress’ midterm elections, souring the public’s view of the economy, weakening President Joe Biden’s approval ratings and raising the likelihood of Democratic losses in November.
Biden has sought to show he recognizes the pain that inflation is causing American households but has struggled to find policy actions that might make a real difference. The president has stressed his belief that the power to curb inflation rests mainly with the Fed.
Yet the Fed’s rate hikes are blunt tools for trying to lower inflation while also sustaining growth. Shortages of oil, gasoline and food are contributing to higher prices. Powell said several times during the news conference that such factors are out of the Fed’s control and may force it to push rates even higher to ultimately bring down inflation.
Borrowing costs have already risen sharply across much of the US economy in response to the Fed’s moves, with the average 30-year fixed mortgage rate topping 5 per cent, its highest level since before the 2008 financial crisis, up from just 3 per cent at the start of the year.
In their updated forecasts Wednesday, the Fed’s policymakers indicated that after this year’s rate increases, they foresee two more rate hikes by the end of 2023, at which point they expect inflation to finally fall below 3 per cent, close to their target level. But they expect inflation to still be 5.2 per cent at the end of this year, much higher than they’d estimated in March.
Over the next two years, the officials are forecasting a much weaker economy than was envisioned in March. They forecast growth will be 1.7 per cent this year and next. That’s below their outlook in March but better than some economists’ expectation for a recession next year.
Even if the Fed manages the delicate trick of curbing inflation without causing a downturn, higher rates will nevertheless inflict pressure on stocks. The S&P 500 has already sunk more than 20 per cent this year, meeting the definition of a bear market.
On Wednesday, the S&P 500 rose 1.5 per cent. The two-year Treasury yield fell to 3.23 per cent from 3.45 per cent late Tuesday, with the biggest move happening after Powell said not to expect three-quarter percentage point rate hikes to be common.
Other central banks are also acting to try to quell inflation, even with their nations at greater risk of recession than the US.
The European Central Bank is expected to raise rates by a quarter-point in July, its first increase in 11 years. It could announce a larger hike in September if record-high levels of inflation persist. On Wednesday, the ECB vowed to create a market backstop that could buffer member countries against financial turmoil of the kind that erupted during a debt crisis more than a decade ago.
The Bank of England has raised rates four times since December to a 13-year high, despite predictions that economic growth will be unchanged in the second quarter. The BOE will hold an interest rate meeting on Thursday. Fed officials forecast unemployment ticking up this year and next, reaching 4.1 per cent in 2024 — a level that some economists said would risk a recession.
Yet Powell largely stuck to his previous reassurances that — with unemployment near a five-decade low, wages rising, and consumers’ finances mostly solid — the economy can withstand higher interest rates and avoid a recession.
“We’re not trying to induce a recession now,” he said. “Let’s be clear about that. We’re trying to achieve 2 per cent inflation.”
But what does that mean for India?
The Federal Reserve interest hike of 75 bps could trigger a churn in equity markets, cool off investor enthusiasm and further weaken the Indian currency against the Greenback.
As per Indian Express, a hike in rates in the US could have a three-pronged impact on India
New Delhi could become less attractive for the currency carry trade as the difference between the interest rate with Washington narrows
Higher returns in the US debt markets could also trigger a churn in emerging market equities, cooling off enthusiasm from foreign investors and enthusiasm.
There is also a potential impact on currency markets, stemming from outflows of funds
As per Times Now, foreign portfolio investors (FPIs) will be encouraged to pull out of markets like India and invest in the relative safety of the greenback.
Reports say foreign investors have pulled out about Rs 14,000 crore so far this month. The net outflow by FPIs from equities reached Rs 1.81 lakh crore so far in 2022.
As investors turn risk-averse and exit India, this is adversely affecting the Indian currency also. The Rupee hit an all-time low this week at 77.82 against the US dollar. It has dipped multiple times in the past months as global uncertainties strengthen the USD. The Indian currency has been weighed down by rising oil prices, besides the Fed rate hikes and FPI exodus.
The Reserve Bank of India has been selling foreign currency to stabilise the rupee. India’s foreign reserves have been depleted from USD $640 billion to USD $600 billion.
With a depreciating rupee, there are concerns of “importing” inflation. Since India buys significant amounts of crude, electronics, and gold, the weakening rupee would increase these goods’ landing cost and push up prices. India’s retail inflation had improved to 7.04 per cent in May after a record-high in April, but it remains above the RBI’s comfort level.
Bank of Baroda chief economist Madan Sabnavis told News18, “There is no direct impact of US Fed hike on consumer prices in India. However, foreign funds in India will be adversely affected and may see outflow, which could make the rupee weaker against the dollar. A weaker rupee has an impact, indirectly, on inflation in India as it makes imports costlier.”
With inputs from agencies
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