- Date : 10/10/2022
- Read: 7 mins
On 21 September 2022, the US Fed hiked US interest rates by 75 bps. This led to rate hikes by the Bank of England and other central banks. The RBI hiked the repo rate by 50 bps on 30 September 2022.
In August 2022, the inflation rate in the US eased to 8.3% from the June high of 9.1%. However, the 8.3% inflation rate is still way above the US Fed’s inflation target of 2%.
Chart: US inflation trajectory
(Source: https://tradingeconomics.com/united-states/inflation-cpi)
The above chart shows how the US inflation has been running high since September 2021 to reach a multi-decade high of 9.1% in June 2022 before settling at 8.3% in August 2022. Hence, the US Federal Open Market Committee (FOMC) has been hiking interest rates since March 2022. In each of the last three meetings, the FOMC has hiked interest rates by 0.75%. With the latest US Fed rate hike of 0.75% in September 2022, the current Fed interest rate is in the 3.00%-3.25% range.
Chart: US Federal Funds rate
(Source: https://ycharts.com/indicators/effective_federal_funds_rate)
The above chart shows how the US interest rates spiked from 0% to 3.0% in less than a year - an unprecedented rate.
Also Read: Personal Inflation Vs CPI Inflation: What's The Difference?
Federal Reserve’s ‘Dot Plot’ projections
During the September 2022 FOMC meeting, while the 0.75% rate hike was expected, two things spooked investors:
- The Federal Reserve’s Dot Plot projected the 2022 year-end median rate target at 4.375%, indicating more rate hikes this year. For 2023, the median rate is expected to reach 4.625%, which is higher than the peak rate that the investors were expecting earlier.
- The Dot Plot also indicated that the interest rates will stay high throughout 2023, and a rate cut can be expected only in 2024.
To put it another way, the Fed doesn’t expect the inflation rate to fall within its 2% target rate anytime soon. So, investors will have to live with higher interest rates for longer than expected. The high interest rates have also increased the probability of the US economy falling into a recession. This certainly does not augur well for global markets, including the US and Indian stock markets.
Impact of US high interest rates on the Indian economy
You must be wondering how does the US Fed rate affect India. The high interest rates in the US impact the Indian economy in multiple ways. Let us understand some of these implications.
1) Impact on the Indian Rupee
The increase in the US Fed interest rate is having a positive impact on the US Dollar, with it strengthening against most global currencies, including the Indian Rupee.
Chart: US Dollar Index
(Source: https://in.tradingview.com/symbols/TVC-DXY/)
The above chart shows how the US Dollar Index has appreciated by around 17% (from 96 to 112 levels) since the start of 2022. Along with other global currencies, the Indian Rupee has also been feeling the heat from the US Dollar strength. Since the start of 2022, the Indian Rupee has depreciated from levels of around 74.36 per USD to levels of around 81.41 per USD as of 30 September 2022. The Indian Rupee hit a lifetime low of 82.02 against the US Dollar on 28 September 2022.
A weaker Rupee leads to costlier imports for India. India imports far more goods than it exports. A weaker Rupee makes our crude oil, commodities, and other imports costlier. These go as raw material for most finished goods, making them costlier. It results in higher inflation for us.
Also Read: What Is Lifestyle Inflation? Four Tips To Avoid Lifestyle Inflation
2) Impact on Indian Current Account Deficit (CAD)
Since our imports by far exceed our exports, the difference increases our Current Account Deficit (CAD). A higher CAD beyond a certain limit may become unsustainable and raise questions as to how we will be able to fund it. A higher trade deficit can deter foreign investors and lead to a flight of capital from the country. A very high CAD can put further pressure on the Indian Rupee, a sovereign rating downgrade by credit rating agencies, and make us vulnerable to economic shocks.
3) Impact on India’s forex reserves
As the US Dollar has been strengthening, the Indian currency has been weakening. The Reserve Bank of India (RBI) has been selling US Dollars to ensure an orderly depreciation of the Indian Rupee so that it doesn’t go into a free fall. But defending the weak Indian Rupee against a strong US Dollar comes at the cost of selling precious foreign exchange reserves.
According to an article published in The Hindu Business Line on 29 September 2022, India's forex reserves have fallen from $633.6 billion (at the start of 2022) to 545.6 billion (as of 16 September 2022). This means a fall of 13.88% in our forex reserves since the start of 2022. Declining forex reserves reduces India’s import cover, which is not good for our economy.
Chart: India’s forex reserves
So, defending the weak Indian Rupee against a strong US Dollar has led to our precious forex reserves declining to a two-year low.
4) Impact on foreign portfolio flows
The high interest rates in the US make it attractive for Foreign Portfolio Investors (FPIs) to invest in fixed income instruments in their home country (the US). Also, the depreciating Indian Rupee impacts the profits of FPI on their investments in India.
For example, at the start of 2022, if an FPI bought one US Dollar in India for investing in Indian stock markets, they would have got Rs 74 per USD. Let us assume the FPI sold their Indian equity investment in September 2022 for the same price at Rs 74. Now, if they convert the Rs 74 at the current USD conversion rate of Rs 81, they will get only 0.91 USD. So, the Indian Rupee depreciation has led to a loss of 9% for the FPI.
In effect, a combination of high interest rates in the US and a depreciation in the Indian currency can lead to FPIs selling Indian equities. The sale proceeds from Indian equities can be invested in US fixed-income products.
5) Impact on RBI’s monetary policy
While the US Federal Reserve has been hiking interest rates, it has compelled other global central banks (including India’s) to increase interest rates to defend their currencies. A strong Dollar leads to imported inflation for India and a fall in the Indian currency and forex reserves. Hence, the RBI is compelled to increase interest rates to protect the Indian Rupee.
Chart: RBI monetary policy rates
(Source: https://tradingeconomics.com/india/interest-rate)
The above chart shows how the RBI has been increasing rates since April 2022. In the latest monetary policy meeting on 30 September 2022, the RBI increased the Repo Rate by 50 bps to 5.9%. All the above interest rate hikes by the RBI cannot be solely attributed to defending the Indian currency. The rate hikes are a result of interest rates and liquidity normalisation post COVID, controlling domestic inflation and, of course, supporting the Indian Rupee.
High interest rates increase the cost of borrowing. For individuals, home loans, personal loans, and other loan EMIs go up. For corporates, high finance costs put pressure on margins. High finance costs also make some projects unviable. All of these can lead to lower profitability or losses for some corporates. This can result in a fall in stock markets.
Also Read: Should You Resort To Gold During Inflation?
Conclusion
The Fed rate hikes have led to multi-year high interest rates in the US. This has led to the strengthening of the US Dollar and the weakening of the Indian Rupee. A weak Indian currency is making imports costly for us, leading to imported inflation and an increase in the current account deficit. The high US interest rates and weak Rupee are also making FPIs sell Indian equities and invest in US fixed income. The foreign portfolio outflow and RBI selling US Dollars to defend the Indian Rupee has led to our forex reserves falling to a two-year low.
To control inflation and defend the Indian Rupee, the RBI has to resort to interest rate hikes, leading to an increase in borrowing costs for individuals and corporates. So, overall, the Fed rate hikes are having a detrimental impact on the Indian economy.
In August 2022, the inflation rate in the US eased to 8.3% from the June high of 9.1%. However, the 8.3% inflation rate is still way above the US Fed’s inflation target of 2%.
Chart: US inflation trajectory
(Source: https://tradingeconomics.com/united-states/inflation-cpi)
The above chart shows how the US inflation has been running high since September 2021 to reach a multi-decade high of 9.1% in June 2022 before settling at 8.3% in August 2022. Hence, the US Federal Open Market Committee (FOMC) has been hiking interest rates since March 2022. In each of the last three meetings, the FOMC has hiked interest rates by 0.75%. With the latest US Fed rate hike of 0.75% in September 2022, the current Fed interest rate is in the 3.00%-3.25% range.
Chart: US Federal Funds rate
(Source: https://ycharts.com/indicators/effective_federal_funds_rate)
The above chart shows how the US interest rates spiked from 0% to 3.0% in less than a year - an unprecedented rate.
Also Read: Personal Inflation Vs CPI Inflation: What's The Difference?
Federal Reserve’s ‘Dot Plot’ projections
During the September 2022 FOMC meeting, while the 0.75% rate hike was expected, two things spooked investors:
- The Federal Reserve’s Dot Plot projected the 2022 year-end median rate target at 4.375%, indicating more rate hikes this year. For 2023, the median rate is expected to reach 4.625%, which is higher than the peak rate that the investors were expecting earlier.
- The Dot Plot also indicated that the interest rates will stay high throughout 2023, and a rate cut can be expected only in 2024.
To put it another way, the Fed doesn’t expect the inflation rate to fall within its 2% target rate anytime soon. So, investors will have to live with higher interest rates for longer than expected. The high interest rates have also increased the probability of the US economy falling into a recession. This certainly does not augur well for global markets, including the US and Indian stock markets.
Impact of US high interest rates on the Indian economy
You must be wondering how does the US Fed rate affect India. The high interest rates in the US impact the Indian economy in multiple ways. Let us understand some of these implications.
1) Impact on the Indian Rupee
The increase in the US Fed interest rate is having a positive impact on the US Dollar, with it strengthening against most global currencies, including the Indian Rupee.
Chart: US Dollar Index
(Source: https://in.tradingview.com/symbols/TVC-DXY/)
The above chart shows how the US Dollar Index has appreciated by around 17% (from 96 to 112 levels) since the start of 2022. Along with other global currencies, the Indian Rupee has also been feeling the heat from the US Dollar strength. Since the start of 2022, the Indian Rupee has depreciated from levels of around 74.36 per USD to levels of around 81.41 per USD as of 30 September 2022. The Indian Rupee hit a lifetime low of 82.02 against the US Dollar on 28 September 2022.
A weaker Rupee leads to costlier imports for India. India imports far more goods than it exports. A weaker Rupee makes our crude oil, commodities, and other imports costlier. These go as raw material for most finished goods, making them costlier. It results in higher inflation for us.
Also Read: What Is Lifestyle Inflation? Four Tips To Avoid Lifestyle Inflation
2) Impact on Indian Current Account Deficit (CAD)
Since our imports by far exceed our exports, the difference increases our Current Account Deficit (CAD). A higher CAD beyond a certain limit may become unsustainable and raise questions as to how we will be able to fund it. A higher trade deficit can deter foreign investors and lead to a flight of capital from the country. A very high CAD can put further pressure on the Indian Rupee, a sovereign rating downgrade by credit rating agencies, and make us vulnerable to economic shocks.
3) Impact on India’s forex reserves
As the US Dollar has been strengthening, the Indian currency has been weakening. The Reserve Bank of India (RBI) has been selling US Dollars to ensure an orderly depreciation of the Indian Rupee so that it doesn’t go into a free fall. But defending the weak Indian Rupee against a strong US Dollar comes at the cost of selling precious foreign exchange reserves.
According to an article published in The Hindu Business Line on 29 September 2022, India's forex reserves have fallen from $633.6 billion (at the start of 2022) to 545.6 billion (as of 16 September 2022). This means a fall of 13.88% in our forex reserves since the start of 2022. Declining forex reserves reduces India’s import cover, which is not good for our economy.
Chart: India’s forex reserves
So, defending the weak Indian Rupee against a strong US Dollar has led to our precious forex reserves declining to a two-year low.
4) Impact on foreign portfolio flows
The high interest rates in the US make it attractive for Foreign Portfolio Investors (FPIs) to invest in fixed income instruments in their home country (the US). Also, the depreciating Indian Rupee impacts the profits of FPI on their investments in India.
For example, at the start of 2022, if an FPI bought one US Dollar in India for investing in Indian stock markets, they would have got Rs 74 per USD. Let us assume the FPI sold their Indian equity investment in September 2022 for the same price at Rs 74. Now, if they convert the Rs 74 at the current USD conversion rate of Rs 81, they will get only 0.91 USD. So, the Indian Rupee depreciation has led to a loss of 9% for the FPI.
In effect, a combination of high interest rates in the US and a depreciation in the Indian currency can lead to FPIs selling Indian equities. The sale proceeds from Indian equities can be invested in US fixed-income products.
5) Impact on RBI’s monetary policy
While the US Federal Reserve has been hiking interest rates, it has compelled other global central banks (including India’s) to increase interest rates to defend their currencies. A strong Dollar leads to imported inflation for India and a fall in the Indian currency and forex reserves. Hence, the RBI is compelled to increase interest rates to protect the Indian Rupee.
Chart: RBI monetary policy rates
(Source: https://tradingeconomics.com/india/interest-rate)
The above chart shows how the RBI has been increasing rates since April 2022. In the latest monetary policy meeting on 30 September 2022, the RBI increased the Repo Rate by 50 bps to 5.9%. All the above interest rate hikes by the RBI cannot be solely attributed to defending the Indian currency. The rate hikes are a result of interest rates and liquidity normalisation post COVID, controlling domestic inflation and, of course, supporting the Indian Rupee.
High interest rates increase the cost of borrowing. For individuals, home loans, personal loans, and other loan EMIs go up. For corporates, high finance costs put pressure on margins. High finance costs also make some projects unviable. All of these can lead to lower profitability or losses for some corporates. This can result in a fall in stock markets.
Also Read: Should You Resort To Gold During Inflation?
Conclusion
The Fed rate hikes have led to multi-year high interest rates in the US. This has led to the strengthening of the US Dollar and the weakening of the Indian Rupee. A weak Indian currency is making imports costly for us, leading to imported inflation and an increase in the current account deficit. The high US interest rates and weak Rupee are also making FPIs sell Indian equities and invest in US fixed income. The foreign portfolio outflow and RBI selling US Dollars to defend the Indian Rupee has led to our forex reserves falling to a two-year low.
To control inflation and defend the Indian Rupee, the RBI has to resort to interest rate hikes, leading to an increase in borrowing costs for individuals and corporates. So, overall, the Fed rate hikes are having a detrimental impact on the Indian economy.
