Fed Hikes Rate by 0.5%: How Will it Impact Investors?

Key Points

• The US Central Bank raised its benchmark interest rates by 0.50%  to a targeted range between 4.25%-4.50%.
• The benchmark interest rate is now at the highest level in 15 years.
• The Central Bank believes that the fight against inflation is not yet over, indicating that the rate hikes will not be halted in the near future. Notably, expectations of a reduction are not there till 2024.
• The Central Bank lowered the GDP growth rates for 2023 to 0.5% from 1.2% in September while increasing inflation outlook to 4.8%.
• Moreover, the Central Bank expects unemployment levels to be at 4.6%, which is higher than its September projection of 4.4%. 

Introduction

The US Central Bank raised its benchmark interest rate by 0.5% to a targeted range between 4.25%-4.50%. This is the highest level in 15 years. Although it is slower than the series of 0.75%hikes in recent times, the Central Bank’s hawkish tone suggests that the fight against inflation is not yet over. Now, how will this rate hike affect the investors? How will it impact businesses? Let’s find out.

Benchmark Interest Rates in 2022:

How Did US Inflation Fare in 2022?

How Will the Rate Hike Impact Business?

Let’s check out with a simple example, how a rate hike by the Central Bank affects a business.

When the interest rate goes up, the cost of borrowing money from the bank increases. If the cost of borrowing is high, what goes down and why? 

Let us assume company A had a budget of Rs 100 crore for its new project. It planned to take a loan of Rs 90 crore at approximately a 10% interest rate. Hence the project cost will come to be Rs 100 crore approximately after paying interest.

In this case, the company would be spending Rs 90 crore on different things as part of the project. 

With an increase in the cost of borrowing, with the same budget of Rs 100 crore, the company can only spend Rs 85 crore as it has to pay Rs 15 crore as interest. 

The same will hold for thousands of other businesses, and the overall spending will reduce in the country. When the spending reduces, the demand also reduces. With the drop in demand, the price of everyday goods also drops. With the fall in the prices of items, inflation is controlled.

To sum up - increasing the borrowing costs discourages businesses from expanding via loans which reduces demand and brings prices down.

Impact on Investors

Impact on Equity Investors: A hike in interest rates by the Central Bank makes loans costlier for businesses. Consequently, they are unable to go for expansion and grow. This in turn affects their profitability, margins, and ultimately the stock price. Thus, an increase in interest rates is not a good sign for investors in the equity market.

Impact on Bond Investors: There is an inverse relationship between bond prices and interest rates. It means that as interest rates rise, the price of bonds declines. Further, longer the maturity of the bond, the more it is exposed to the volatilities of the interest rates. Therefore, it can be safely concluded that a rising interest rate scenario is not suitable for bond investors.

Impact on India

Weaker Rupee: With increasing interest rates in the US, the difference between Indian and US interest rates shrinks. As a result, the Indian markets see capital going out of the country. This is because the Indian market is considered riskier than the US market. Consequently, the rupee gets weaker and import costs rise. 

Worsening inflation in India: India’s inflation rate may accelerate as a result of the Fed rate hike. Depreciation of the rupee will increase the rupee cost of imported goods such as chemicals and fertilizers, electronics, crude oil, and active pharmaceutical ingredients.

Will There Be More Rate Hikes?

Although inflation levels have eased from previous record highs, the Central Bank has indicated that its fight against inflation will continue. As a result, rate hikes will also continue with no reductions in sight till 2024.

The Central Bank is comfortable with an inflation level of 2%, which is currently way above at 7.1%, although it has cooled somewhat.

Some experts are of the opinion that the gradual fall in inflation levels and economic slowdown fears will eventually soften the Central Bank’s stand on rate hikes in the future.