How do Fed rate hikes affect the Indian economy and markets?

In the US, price pressures are accelerating; regardless of the Federal Reserve’s interest rate increase and efforts to scale back pandemic-era liquidity surplus. The newest rise print was a nightmare. Price increase in the US rose to a 41-year high of 9.1 per cent from a year ago in June. This is higher than evaluations and way above the Fed’s target of 2 per cent.

A Fed Rate Hike: What is it?

A Fed Hike is a rise in the main policy rate of the US central bank, called the US Federal Funds Target Rate. Rate hikes are associated with the peak of the economic cycle and are meant to slow down inflation to apply the brakes in an overheating economy.

The US Fed increases interest rates: Why?

Worldwide economies are in a downturn owing to high inflationary pressure. To fight this, the Fed, which is the central bank of the US is taking bold initiatives for instance rise in interest rates to cut the money supply flow in the economy. Chaitali Dutta, a personal finance expert explains; “A lower interest rate in the economy allows the public to take more loans (cheaper debt available) to buy new and spend more on buying goods and services. Therefore, the overall supply of money in circulation in the economy increases. This results in higher demand than supply. This demand-supply gap results in an increase in the price of goods and services, which we typically call "inflation"; 

To defy this, the central bank upsurges the interest rate to cut the money supply in the economy, which, consequently, results in a decrease in the price of goods and services. This in the end controls the price rises. Once the Fed increases the rate, it raises the cost of credit across the economy. Sky-scraping interest rates make loans overpriced for both businesses and consumers. Everyone ends up shelling out more on interest payments. Businesses hence may put their volume growth plans on the back burner.

Impact of fed rate hike on the Indian Market

• Heightened risk aversion
• Weaker rupee
• Narrowing interest rate differential
• Upward pressure on bond yields
• Widening trade deficit

To put it in simple words, when the Fed increases its policy rates, the variance between the interest rates of India and the US constricts. This is making developing countries like India less attractive for the currency carry trade. Besides as India is vulnerable to US rates, it could bring about capital flow out of India, and dampen the Indian rupee. Furthermore, experts say, this may bring prolonged imported inflation and additional domestic rate hikes.

Why do changes in US Fed rates disturb the Indian stock market? 

Well, to understand this we need to understand why foreign investors put in money in India. Why don’t they invest in the US? The US is an already developed nation with limited growth opportunities. However, India is still a developing economy with enormous opportunities for evolution.

Besides, interest rates in the US are much more stress-free than in India. Subsequently, foreign investors borrow heavily in the US and infuse that capital into the Indian market. This is because in India interest rates are high. This suggestively decreases their borrowing costs, which could have been higher if they resorted to borrowing the same capital in the Indian financial markets. 

To put it in simple words, borrowing in a market where interest rates are on the lower side and investing in a country where interest rates are mounting high surges the profit spread.

The write-up intends to explain how a deeper Fed rate hike can impact India.