Why in the News?

The US Federal Reserve is expected to raise benchmark rates by 25 bps to the 5.25-5.50 percent range on Wednesday. Investors will be watching for cues on inflation and rate hike trajectory.

About US Federal Reserve:

• The US Federal Reserve, also known as the Fed, serves as the central banking system of the United States, offering a secure, adaptable, and steady monetary and financial framework.
• It operates through 12 regional Federal Reserve Banks, each responsible for a designated U.S. geographic area.
• The Fed's primary functions encompass conducting national monetary policy, overseeing and regulating banks, ensuring financial stability, and delivering banking services.

Impacts of US Federal Reserve Interest Hike:

• The US Fed's Significance: As the world's most powerful central bank, the decisions taken by the US Federal Reserve regarding interest rates have significant implications worldwide. These decisions influence both developed and emerging economies across the globe.
• Global Effects: Changes in US interest rates have a ripple effect that extends beyond the nation's borders. The adjustments impact various economies worldwide, leading to shifts in investment patterns and financial flows.
• Appeal of American Assets: When the Federal Reserve raises interest rates, American assets become more attractive to investors seeking higher returns. Consequently, there is a possibility of capital outflows from emerging and riskier markets to the US.
• Impact on Capital-Intensive Sectors: Sectors heavily reliant on Foreign Direct Investments (FDIs) are particularly vulnerable to the consequences of a US interest rate hike. The increased cost of borrowing may affect their growth prospects.
• Global Liquidity Tightening: Higher US interest rates can lead to a tightening of global liquidity. Foreign investors may face challenges in obtaining affordable funds, which could have implications for their investment decisions and overall economic activities.

Potential Impacts on the Indian Economy:

• Interest Rate Differential: Following a rate hike by the US Federal Reserve, the gap between interest rates in the US and India narrows, adversely affecting currency trade and financial flows.
• Foreign Investor Response: With higher returns available in the US due to increased interest rates and attractive Dollar and US Treasury yields, foreign investors may be inclined to withdraw investments from the Indian market, leading to capital outflows.
• Currency and RBI Response: The relative strengthening of the US currency (Dollar) makes the Indian rupee weaker, prompting the Reserve Bank of India (RBI) to consider a rate hike domestically.
• RBI's Action to Curb Outflows: To mitigate the outflows of funds from Foreign Institutional Investors (FIIs) and safeguard the rupee's stability, the RBI may find it necessary to increase interest rates within India.
• Forex Reserve Management: In the event of a significant decline in the rupee's value, the RBI might be compelled to sell some of its Dollar reserves to support the domestic currency. This action, however, depletes the country's foreign exchange reserves.