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Explained: Understanding the potential impact of Fed rate hike on US and other economies

With the US Federal Reserve signalling a hike in interest rates this March, Anil Sasi explains what this means for the US economy as well as global markets, including India.

Written by Anil Sasi , Edited by Explained Desk | New Delhi |
Updated: January 28, 2022 7:35:46 am
US Federal Reserve Chairman Jerome Powell addresses an online news conference in Washington, January 26, 2022. (US Federal Reserve Board/Handout via Reuters)

The US Federal Reserve is poised to hike interest rates in March as it reaffirmed plans to pull back the support it has provided the American economy since the start of the pandemic.

After the conclusion of a two-day Federal Open Market Committee meeting Wednesday, central bank chair Jerome Powell said such a move “will soon be appropriate” as he pledged a sustained onslaught to tame inflation. The US central bank is under pressure to tame runaway inflation as prices in the world’s largest economy have risen at their fastest rate in almost 40 years. Analysts expect a rate hike in March, which would be the first since 2018.

At a press conference following the meeting of Fed officials, Powell did not say how fast or how high US interest rates would rise, but reaffirmed that officials were “of a mind” to hike the bank’s rates in March. Powell said that inflation has gotten “slightly worse” since the Fed last met in December and that hiking the Fed’s benchmark rate, which has been pegged at zero since March 2020, will help control inflationary expectations from getting deeply entrenched in the American economy.

What is the import of the Fed’s signaling?

While markets have largely factored in the reversal in the Fed’s policy stance, there are concerns that the US central bank would be more aggressive in its intensity of rate hikes, going by the guidance offered by Powell, who said the economy “is stronger” than in 2015 (when the Fed had begun its last rate hike cycle).

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Runaway inflation is being seen as a political headwind for US President Joe Biden ahead of the November midterm elections. Biden said last week it was “appropriate” for Powell to adjust the Fed’s policies. And congressional Republicans, according to an AP report, have endorsed Powell’s plans to raise rates, providing the Fed with rare bipartisan support for tightening credit. Powell reaffirmed the view that policymakers are convinced the American job market is robust enough to let go of the ultra-low interest rates.

How does this impact global markets?

Traders across markets have been looking for signs that the Fed might be more aggressive about rolling back the stimulus that has been feeding stock market gains across geographies. The new projections are being seen as a definitive move to frontload the reversal of the central bank’s expansionary monetary policy put in place in early 2020 to invigorate the American economy amid the Covid-19 outbreak.

Part of this support was in the form of an extraordinary bond-buying programme, which was intended to bring down long-term interest rates and catalyse greater borrowing and spending by both consumers and businesses. It is this plan that is now being wound down, albeit at a faster rate.

Alongside the bond-buying programme, the Fed had also slashed its funds target rate to zero. A faster unwinding of the bond-buying programme also means that interest rate hikes in the US are likely earlier than expected.

What are the concerns at this stage?

The Fed’s announcement has come amid criticism that the US central bank has fallen behind the curve on inflation. The indications from Powell’s interaction is that the Fed will be aggressive in reversing its policy stance, both in terms of hiking interest rates and accelerating the tapering of its bond purchases, scaling back by $30 billion a month instead of the $15 billion pace that it had announced in November.

This opens up the possibility that policymakers could raise the Fed funds rate from its current range of 0% to 0.25% as early as March 2022 and that there is the possibility of four hikes this year.

The US central bank is currently buying $90 billion a month in bonds, down from $120 billion in October, and has been reducing those purchases by $15 billion a month. But in January, it will reduce those purchases by $30 billion, to $60 billion, and will be on track to end them altogether in March, Powell had said at a briefing in December.

When asked about the stock market’s volatility Wednesday, Powell said the Fed’s “ultimate focus” is on the “real economy”, according to a Reuters report. He, however, underscored the point that the Fed has been communicating with stakeholders. “We feel like the communications we have with market participants and the general public are working.”

The three major US stock indexes pared gains during Powell’s remarks, an indication of a cascading impact across other markets around the world. In India, benchmark indices were down in opening trade on Thursday.

The Federal Reserve building in Washington. (Stefani Reynolds/The New York Times)

Why are these signals from the Fed important?

Like other central banks such as the Reserve Bank of India, as the US Fed conducts monetary policy, it influences employment and inflation primarily by using policy tools to control the availability and cost of credit in the economy.

The Fed’s primary tool of monetary policy is the federal funds rate, changes in which influence other interest rates — which in turn influence borrowing costs for households and businesses, as well as broader financial conditions.

Additionally, the bond-buying programme, also known as quantitative easing, was put in place in 2020 as an extraordinary measure to help the financial markets and the economy counter the impact of the pandemic.

This bond buying is an unconventional monetary policy tool (that was deployed during the global financial crisis as well), using which the central bank purchases longer-term securities from the open market in order to increase the money supply and incentivise lending and investment.

Buying these securities augments the supply of new money in the economy, and ends up dampening interest rates, while also expanding the central bank’s balance sheet.

The tapering of the bond-buying plans now signals a move towards policy normalisation, and a progressive reversal of the interest rate trajectory in the economy.

The US Fed is not alone in its intention to hike rates. The Bank of England raised interest rates for the first time in more than three years in December and is expected to do so again in February.

How do rate cycles work?

When interest rates go up in an economy, it becomes more expensive to borrow; so households are less inclined to buy goods and services, and businesses have a disincentive to borrow funds to expand, buy equipment, or to invest in new projects.

A subsequent lowering of demand for goods and services ends up depressing wages and other costs, in turn bringing runaway inflation under control. Even though the linkages of monetary policy to inflation and employment are not direct or immediate, monetary policy is a key factor in tackling runaway prices.

Theoretically, a signal to hike policy rates in the US should be a negative for emerging market economies, especially from a debt market perspective.

Emerging economies such as India tend to have higher inflation and, therefore, higher interest rates than in developed countries. As a result, investors, including Foreign Portfolio Investors, tend to borrow in the US at lower interest rates in dollar terms, and invest that money in the bonds of countries such as India in rupee terms to earn a higher rate of interest.

What will be the impact on other markets, including India?

A hike in rates in the US could have a three-pronged impact.

When the Fed raises its policy rates, the difference between the interest rates of the two countries narrows, thus making countries such as India less attractive for the currency carry trade.

A high rate signal by the Fed would also mean a lower impetus to growth in the US, which could be yet negative news for global growth, especially when China is reeling under the impact of a real estate crisis.

Higher returns in the US debt markets could also trigger a churn in emerging market equities, tempering foreign investor enthusiasm.

There is also a potential impact on currency markets, stemming from outflows of funds.

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