“Have you ever witnessed the creation of ripples when a stone is thrown into a puddle? What exactly do you observe from those ripples? It is a simple demonstration of “For every action in nature, there is an equal and opposite reaction” or Newton’s Third Law. The same is happening currently with the consistent hikes in Fed Interest rates.
What does Fed Interest Rate mean?
The overnight lending rate is the Fed interest rate. It is the interest rate at which commercial banks lend and borrow their excess money to each other overnight. This interest rate is set by the FOMC, Federal Open Market Committee. It is a committee of the US Federal Reserve responsible for setting up monetary policies in the US. It also sets up a target federal funds rate eight times a year, based on prevailing economic conditions.
One can check the historical interest rates from here: https://tradingeconomics.com/united-states/interest-rate
Impact of Fed Interest Rates on Indian Stock Markets
As per the immensely popular proverb of stock markets “When the US sneezes, the entire world catches a cold.” Thus, every time the interest rates change, a ripple emerges in the global markets. Now, let us understand how the US interest rates, affect the Indian and global economies.
1. Strengthening Dollar and Weakening Rupee
Whenever the Fed hikes its interest rates, US Dollar becomes stronger. Thus, due to its increased strength, other major global currencies including the Rupee weaken.
A weaker Indian rupee corresponds to high import costs. This leads to a rise in the prices of most commodities. Thus, crude oil, raw materials, etc., become costlier. This results in increased cost of the final product, thereby making things more expensive than they were available for. The outcome is higher inflation for us and the rest of the world.
2. Issue with Increased Import Costs
With nascent initiatives like Make in India, the country remains to be an import-dependent country. It implies that our imports far exceed our exports. Hence, with increased imports and dollar costs, our Current Account Deficit (CAD) increases. Increased CAD corresponds to unsustainability raising questions and queries about funding. This puts further pressure on the Indian rupee, leading to increased capital. The end outcome is a country powerless against economic shocks.
3. Impact on India’s Forex Reserves
The relation between US Dollar and the Indian rupee has always been inversely proportional. This means, with the increasing strength of the US Dollar, the strength of our currency or the Indian Rupee decreases. To counter this, RBI sells US Dollars to avoid a free fall and ensure a gradual depreciation. But, in the process of defending our weak Indian rupee, our precious foreign exchange reserves deplete.
Fact To Prove This: Our forex reserves have registered a fall of 13.88%. The reserves which were at $633.6 billion at the start of 2022, are now at 540 billion dollars. Declining forex reserves lead to reduced import cover which is a bad sign for our economy.
4. Outflows of Foreign Portfolio Investors
The eventual outcome of the combination of two events – the depreciating Indian rupee and highly attractive US interest rates is Foreign Institutional Investors selling their stake in Indian equities and investing this money in US Fixed Deposits.
5. Changes in The Monetary Policy Of RBI
When the US Fed hikes the interest rates, other global central banks including the Reserve Bank of India increase their interest rates to defend their currencies. With high-interest rates, liquidity in the market is curbed. High-interest rates lead to increased borrowing costs of home loans, EMIs, personal loans, etc., whereas for corporates, due to the increased finance costs, profitability also shrinks. All of this results in a fall in the stock markets.
These are the major impacts of the US Fed Interests rates on the Indian economy and the Indian Stock Markets. We hope that this is now clear to you. For more interesting content, stay tuned to our blogs.