US Fed Hiked Interest Rate by Another 0.75%: What Does It Mean For Indian Investors?

The US Fed increased its interest rate by 75 bps after its recently concluded meeting earlier this week. Will there be a recession? What does it mean for investors in India? Let us look at everything you need to know about the meeting.

Key highlights of the meeting

• The Fed increase of 75bps in key lending rate is the biggest since 1994. 
• The central bank said that it is 'STRONGLY COMMITTED' to return inflation to 2%.
• It has projected a slowing down of the country's economy in the coming months and a likely increase in the unemployment rate.
• The Fed remained concerned about the rising inflation and continued to cite the Russia-Ukraine war and China lockdown as the main reason for inflation.
• Along with the rate increase, the Fed also downgraded the economic outlook. It now sees 1.7% growth this year, unemployment rising to 3.7% by the end of this year, and continuing to rise to 4.1% through 2024.
• No policymaker projected an outright recession. However, analysts are predicting a recession.

Rate hike & Inflation - How are both linked?

Many investors are unsure how the lending rates increase will help the US (or India) bring down inflation. It is crucial to understand it as it helps an investor understand macroeconomics. So let us understand it in the easiest possible way.

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.

The side-effect of bringing inflation down - Recession

By raising interest rates 75bp to 1.75% at its MPC, the Federal Reserve is risking inflation. When the interest rates are increased too quickly, the demand may drop drastically and the repercussions will be felt by the economy. 

If businesses don't expand, or if they stop investing, then they do not hire or fire their workers, leading to higher unemployment. All these can lead to a recession. Most economists are saying that contraction next year would be difficult to avoid.

How will the Fed's rate hike impact the Indian economy?

Weaker Rupee: With increasing interest rates in the US, the Indian market will become less attractive to foreign investors. A rising trade deficit, owing to growth in imports outpacing exports, and several other factors have already caused the Indian rupee to weaken. The latest rate hike by the US Fed will improve yields on US treasuries and reinforce the Dollar’s strength against the rupee.

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?

The inflation in the US is way above normal, and to bring it between 2 and 4%, the Fed has a big task. Federal Reserve Chair Jerome Powell has said that the central bank could raise interest rates by a similar magnitude at the next policy meeting in July. He also added that either a 50 basis point or a 75 basis point increase seems most likely in Fed's next meeting.

Some experts suggest that the central bank should be more aggressive to restore market confidence. They recommend a series of 1% point hikes would be more efficient in tamping down inflation. 

Let us see how the inflation numbers come in the coming months and what the Fed does to bring it down.