BL Explainer

Explainer: US Fed's actions and impact on India

Lokeshwarri SK | | Updated on: Dec 16, 2021
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Why is US Federal Reserve tightening US monetary policy?

The US Federal Reserve was at the forefront in preventing a global recession when Covid-19 hit the world in 2020. The Fed went all out to support the economy; practically throwing the kitchen sink at it. You can get a sense of the scale of this stimulus by looking at the balance sheet of the US Federal Reserve – it has more than doubled from $4.1 trillion in March 2020 to $8.6 trillion now. A bloated balance sheet means an equivalent increase in the government debt. With the economy getting back on its feet and labour market back to pre-pandemic levels, the Fed is beginning to move towards trimming its balance sheet back, to size.

The other critical reason for monetary tightening is the impact of the surplus funds in the economy on inflation. US inflation as measured by Personal Consumption Expenditure (PCE) index hit multi-decade high at 5 per cent in October. This is far above Fed’s tolerance of 2 per cent. In this monetary policy, the Fed has doubled the reduction of monthly bond purchases. It plans to completely halt its purchases of US treasury bonds and mortgage-backed securities by March next year.

Will it start increasing interest rates in US soon?

Yes, there are strong indications in the FOMC projections that rates will be moving up sharply in 2022. The Federal Reserve Board members are now projecting that the Fed Funds rate will be in the range of 0.6 to 0.9 per cent in 2022 and 1.4 to 1.9 per cent in 2023. The rate is currently 0.1 per cent. The projections in September indicated that rate will be between 0.1 to 0.4 per cent in 2022. Therefore, the Board members are all veering towards aggressive rate hikes over the next two years.

How will these actions impact emerging markets like India?

The reduction in funds infused by the Fed and increase in fed funds rate will impact the availability and cost of overseas finance for Indian companies. The indirect impact is of foreign portfolio flows in to Indian equity and bond markets. Global investors borrow in currencies with zero or low interest rates to invest in assets across the world. This is called carry trade, which is partly responsible for the raging rally in stocks in India and elsewhere. As rates begin moving up, the carry trade can reverse causing global sell-off. But the solace for stock markets is that not all central banks think alike. While Fed is tightening, the European Central Bank and the Bank of Japan are likely to continue easy monetary policy, thus mitigating the Fed’s actions somewhat.

Will it cause interest rates to go up in India too?

Yes, the actions of Fed will definitely influence the RBI. If interest rates in US increase, the spread between US and Indian government bonds will narrow causing global funds to pull money out of Indian G-secs. RBI will therefore have to raise interest rates in India to prevent FPI outflows from Indian bond market.

How will Fed's actions affect the rupee?

The rupee is impacted by three factors. One, the US dollar will strengthen further as interest rates of dollar denominated securities begin moving higher. This will make rupee decline. Two, if FPIs continue to pull money out of stock and bond markets that will weaken the rupee too. Three, if global risk aversion increases, money is typically pulled out of riskier assets such as emerging market assets in to safe havens such as gold and US treasury instruments. This will impact rupee too.

Published on December 16, 2021

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