US Fed keeps rates steady amid high Inflation

What’s in today’s article?

• Why in News?
• Inflation in US
• Why are these signals from the US Fed important?
• What will be the impact on other markets, including India?

Why in News?

The US Federal Reserve announced that it is keeping its benchmark rate unchanged due to an uptick in inflation. It said that agency would continue to watch incoming price data before taking a call on when to cut rates. This is significant as at the start of this year, most analysts had predicted a rate cut by the Fed at its May 1 meeting and a total of three rate cuts in 2024.

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Inflation in US

• According to data released by the US Labour Department’s Bureau of Labour Statistics on April 10, the consumer price index in the US increased by 0.4 per cent month-on-month and surged 3.5 per cent year-on-year.
• US Fed Chair said that inflation was still too high and rate cuts would not be considered until price growth starts moving down towards its 2 per cent target.
• The Chairman also mentioned that there is no guarantee of making more progress in reducing inflation, and the future course is uncertain.

Why are these signals from the US Fed important?

• Monetary Policy and Its Impact
  • Like other central banks such as the RBI, the US Federal Reserve conducts monetary policy to influence employment and inflation.
  • Policy tools are used to control the availability and cost of credit in the economy.
  • The Fed’s main tool of monetary policy is the federal funds rate. Changes in this rate influence other interest rates in the economy.
• Impact on Borrowing Costs
  • When interest rates decrease, borrowing becomes cheaper for households and businesses.
  • Lower borrowing costs incentivize households to increase spending on goods and services.
  • Businesses are motivated to borrow funds to expand operations, purchase equipment, or invest in new projects.
  • By adjusting interest rates, the Federal Reserve aims to stimulate or slow down economic activity, thus influencing employment levels and the rate of inflation in the economy.
• Impact on growth cycle
  • Improved demand for goods and services ends up pushing up wages, and helps rekindle the growth cycle. 
  • Although the linkages of monetary policy to inflation and employment are not direct or immediate.
  • However, monetary policy is a key factor in curbing runaway prices or stoking the growth impetus.
• Significance for emerging market economies
  • A signal to cut policy rates in the US should be a positive for emerging market economies, especially from a debt market perspective. 
  • Emerging economies such as India tend to have higher inflation and, therefore, higher interest rates than in developed countries.
  • As a result, investors tend to borrow in the US at lower interest rates in dollar terms, and invest that money in the bonds of countries such as India in rupee terms to earn a higher rate of interest.

What will be the impact on other markets, including India?

• Currency Carry Trade Opportunity
  • A rate cut by the US Federal Reserve could widen the interest rate differential between the US and other countries.
  • This makes countries like India more appealing for currency carry trade, as investors seek higher returns.
    • A currency carry trade is a foreign currency trading strategy.
    • It involves borrowing money from a currency with a lower interest rate to fund the purchase of a currency with a higher interest rate. 
    • The goal is to profit from the difference between the two interest rates, which can be substantial depending on the amount of leverage used.
  • The attractiveness of the carry trade increases until other economies also start cutting rates.
• Boost to US Growth and impact on global economic scenario
  • Lower rates signal a push for growth in the US economy.
  • This positive outlook for US growth is beneficial for global economic expansion, particularly amidst concerns over China’s real estate crisis and slowing growth.
  • Reduced returns in US debt markets may prompt investors to shift towards emerging market equities, boosting foreign investor sentiment.
• Impact on Currency Markets
  • Inflows of funds driven by lower US rates can influence currency markets.
  • Changes in currency valuations could occur as a result of these fund inflows, impacting global trade dynamics and financial markets.
• Decisions of Central Banks of other countries
  • For the RBI, like other central banks, the likelihood of a future rate cut is somewhat predicated on the US Fed’s decision to cut rates.
    • Recently, on April 5, the RBI had kept the repo rate unchanged for the seventh consecutive time at 6.5 per cent.
    • This has raised expectations of a rate cut later this year, but in all probability that could happen only after the US Fed cuts its benchmark rates.

Q.1. What is the U.S. Federal Reserve?

The Federal Reserve is the most powerful economic institution in the United States. It is responsible for managing monetary policy and regulating the financial system.

Q.2. What is currency carry trade?

A currency carry trade is a foreign currency trading strategy. It involves borrowing money from a currency with a lower interest rate to fund the purchase of a currency with a higher interest rate. The goal is to profit from the difference between the two interest rates, which can be substantial depending on the amount of leverage used.