The US Federal Reserve hiked the interest rates by 25 bps on Wednesday and signaled a faster speed of rate increases in 2017 as the Trump administration takes over with assurance to boost growth through tax cuts, spending and deregulation.
The rate increase, considered as a virtual certainty by financial markets in the wake of a series of generally strong economic reports, raised the target Federal Funds rate 25 basis points to between 0.50 percent and 0.75 percent.
What really happened?
The Fed increased its standard interest rate, the so-called fed funds rate, to the range of 0.50 per cent to 0.75 per cent from 0.25 per cent to 0.50 per cent. The rate is still astonishingly low. During the financial crisis, the Fed cut the rate to near zero and kept there for seven years. By dropping borrowing costs, the Fed hoped to push consumers and businesses to spend and get the economy out of the deepest recession since the 1930s. Economists say the low rates helped revitalize the economy though the recovery has been dull by historical standards.
Why the hike?
Yesterday, the Fed said that the American job market looks robust and the overall economy is expanding at a moderate pace. The unemployment rate declined in November to a nine-year low of 4.6 per cent. And the economy stretched from July through September at a 3.2 per cent annual rate, fastest in two years. The Fed expects inflation to edge-up and closer to its 2 per cent annual target.
Steady with its statutory mandate, the Committee seeks to promote maximum employment and price stability. The Committee anticipates that, with gradual adjustments in the position of monetary policy, economic activity will expand at a moderate pace and labor market conditions will reinforce somewhat further.
In view of realized and expected labor market situation and inflation, the Committee resolute to raise the target range for the federal funds rate to 1/2 to 3/4 percent. The stance of monetary policy stays accommodative, thereby supporting some further strengthening in labor market conditions and a return to 2 percent inflation.
Broader Implications
Economists don’t anticipate the higher borrowing costs to do much harm to steady but unglamorous US economic growth. But higher US rates are likely to pull investors away from the rock-bottom rates in Europe and Japan. Turning to US investments, they are likely to drive up the value of the dollar, which is already near a 14-year high. An expensive Dollar makes US products costlier in foreign markets and harm American exporters. A higher dollar will also grasp foreign companies that borrowed in US dollars; to make loan payments, they will require exchanging more of their cheaper local currency into American dollars.
Impact on Dollar and Rupee:
The interest rate hike demonstrates the strength in the US economy, ultimately sending a strong signal to the Dollar against a basket of currencies. However, noteworthy strengthening of the dollar would indeed cause grave problems for emerging economies such as India. A rate hike by US Fed will send out a strong signal to the currency as well as equity markets, which will bring the rupee down against the dollar. Foreign investors in Indian markets will pull out their money and invest in the US market. Also, the depreciation of the rupee will lead to higher current account deficit and higher inflation.
Impact on Indian Market:
It was predicted that Indian markets could observe a negative reaction once it opens for trading on Thursday, i.e. today on Fed hawkish commentary on future rates hikes. But as the market opened for trade today, both the bourses were seen trading in positive. Nifty share price was trading at 8221.65 levels, up by 0.48 per cent while, BSE S&P Sensex was seen at 26,718.47 levels, up by 0.43 per cent
Of late, foreign institutional investors (FIIs) have been selling their holdings in Indian stocks due to the demonetization, and uncertainty over rate hike by the US Fed. The Fed policy is slightly hawkish as pointed out by three rate increases expected in 2017 compared with two rate increases anticipated in September’s statement. It appears to be Fed’s retort to the incoming administration’s stated quest of strong reflationary policies and fiscal spur impacting medium term inflationary outlook. The emerging market currencies and equities may come under pressure and bond yields may increase with the higher number of rate increases by Fed in 2017.