Impact of US Federal Reserve rate hike on India Final

The Federal Open Market Committee (FOMC) stated that inflation remains elevated, reflecting supply and demand imbalances related to the pandemic and higher energy prices

Impact of US Federal Reserve rate hike on India Final

The US Federal Reserve (Fed) announced its biggest interest rate hike in more than two decades to fight against rising inflation. The US consumer price index came at a 40 year high of 8.5% in March 2022. As expected, the Fed hiked the lending rate by 50 basis points (bps) to a range of 0.75% to 1% on May 4, 2022. The Federal Open Market Committee (FOMC) stated that inflation remains elevated, reflecting supply and demand imbalances related to the pandemic and higher energy prices. The Fed Chief Jerome Powell said that he wants to quickly raise the Fed’s rate to a level that neither stimulates nor restrains economic growth. With aggressive tightening, the Fed expects inflation to return to its 2% objective and the labour market to remain strong. Note, Fed had kicked off a new tightening cycle by raising the benchmark interest rate by 25 bps to a range of 0.25 to 0.5% on March 16. 

As seen in the chart above that although the Fed policy actions moves in tandem with inflation scenario; the US been the largest economy in the world. And actions taken by the US central bank have widespread implications in the world especially on the emerging markets like India since there it has massive foreign inflows and trade relations. US was India’s top trading partner in 2021. Hence, it is crucial to evaluate the impact of Fed actions on the Indian economy and markets.

Outflows from the emerging markets like India

Higher interest rate in US is likely to accelerate the foreign outflows from emerging markets like India as investors get higher returns on US treasury yield. From June 2022, US Fed will start trimming its multi-trillion-dollar balance sheet which currently stands at nearly $9 trillion which will drain the liquidity from the system. Looking at the foreign investors investment pattern back home, foreign portfolio investors (FPI) have pulled out Rs 1.32 lakh crore from Indian equity market and Rs 9,155 crore from the Indian debt market on the year till date basis till May 4, 2022. Rapid outflows often increase volatility in the financial markets. In the past, the Fed hikes caused knee-jerk reactions in the Indian markets denting investors’ confidence largely.

Rupee suffers as the rate hike strengthens the US dollar

The US interest rate hike makes dollar stronger and weakens the rupee. Such weakness in the rupee puts greater pressure on the import cost which is already rising sharply due to higher oil prices, increase in the other commodity prices and pickup in the domestic demand amid reopening of the economy. Faster increase in imports is likely to inflate the trade deficit and also widen the current account deficit.

Increases cost of borrowing in the overseas market

Indian companies often raise cheap overseas money to meet their capital needs through external commercial borrowings. Indian firms who have borrowed a large amount of money in dollars in the overseas market is likely to witness greater interest burden owing to higher cost of borrowing post rate hike.

Concerns about rising US treasury bond yields 

The US treasury yields has seen a gradual increase due to rising expectations of the economic recovery post pandemic and elevated inflation levels. The 10-year US treasury bond yields have surged from 1.59% on May 4, 2021 to 2.95% on May 4, 2022. Higher bond yields create panic in the equity market since the valuations are based on the discounted cash flow (DCF) method, wherein future cash flows are discounted using cost of capital. In case bond yields go up, cost of capital also goes up depressing equity valuations. Investors start pulling money out from the Indian markets and get better returns by investing in the US treasury market.

Summing up

As inflation becomes the biggest threat the central banks across the globe have started the monetary tightening. While the Fed hike was widely anticipated, such policy moves often causes intermittent volatility in the financial markets. Investors back home need not panic instead hold a well-diversified portfolio mapped to risk appetite and goals. Continue to remain invested for the longer term as policy makers across the globe remains committed to price stability and support economic growth.