Globally economies are in a recession due to high inflationary pressure. To combat this, the Fed, which is the central bank of the USA, is taking aggressive steps such as an increase in interest rates (something which was not seen since the 1990s) to reduce money supply in the economy.
A lower interest rate in the economy allows the public to take more loans (Cheaper debt available) to buy new assets and spend more on buying goods and services. Therefore, the overall supply of money in circulation in the economy increases. This results in higher demand than supply. This demand supply gap results in an increase in the price of goods and services, which we typically call “Inflation”.
To combat this, the central bank increases the interest rate to reduce the money supply in the economy, which, therefore, results in a reduction in the price of goods and services. This eventually controls the inflation.
When the Fed raises the rate, it increases the cost of credit across the economy. Higher interest rates make loans more expensive for both businesses and consumers, and everyone ends up spending more on interest payments. Businesses therefore may put their capacity expansion plans on the back burner.
How Does it impact India?
1. When the Fed raises its policy rates, the difference between the interest rates of India and the USA narrows. This makes the emerging economies such as India less attractive for currency carry trade. (A currency carry trade is a strategy whereby a high-yielding currency funds the trade with a low-yielding currency.)
3. And since India is vulnerable to US rates, it could lead to capital outflow from India.
4. It can depress the Indian rupee further. (Rupee depreciation)
5. It can prolong import inflation and prompt more domestic rate hikes.
6. Cross border investment flow will also become restrained as global liquidity has tightened.
7. Profitability of corporates will be hit.
8. The depreciating rupee will add to the import cost and overall growth of India slows down.
Hence the Fed rate hike will keep the rupee very volatile in the near term.
