The US Federal Reserve recently raised its benchmark lending rate to the highest level since 2001 to tackle above-target inflation.
About US Federal Reserve:
- The United States Federal Reserve, commonly referred to as the Federal Reserve or simply the Fed, is the central banking system of the United States.
- It provides the country with a safe, flexible, and stable monetary and financial system.
- The Federal Reserve System is composed of 12 regional Federal Reserve Banks that are each responsible for a specific geographic area of the U.S.
- The Fed's main duties include conducting national monetary policy, supervising and regulating banks, maintaining financial stability, and providing banking services.
Impacts of US Federal Reserve Interest Hike:
- The US Fed is the world's most powerful central bank.
- When the Fed adjusts interest rates, the effects are felt worldwide, influencing both developed and emerging economies.
- Conventional wisdom suggests that higher interest rates in the US would make American assets more appealing to investors, potentially leading to capital outflows from emerging and riskier markets.
- In such a scenario, capital-intensive sectors, which heavily rely on Foreign Direct Investments (FDIs), could be the first to feel the impact.
- Higher US interest rates could lead to a tightening of global liquidity, making borrowing more expensive for foreign investors.
Possible impacts on the Indian Economy:
- After a rate hike by the US Fed, the difference between interest rates in US and India shrinks, which affects the currency trade negatively.
- Foreign investors will be tempted to withdraw from the Indian market and invest in US assets, as the Dollar and the US Treasury yield become more attractive in the US and the Indian market begins to see capital outflow.
- Thus, an interest rate hike in the US increases the relative returns on dollar investments, leading the US currency to strengthen.
- This makes the rupee weaker, and it prompts RBI for a rate hike in India.
- So when the US Fed increases rates, RBI also has to increase interest rates here in India so that the outflows of funds from the FIIs (Foreign Institutional Investors) can be curtailed to save guard the rupee.
- If the rupee falls significantly, the RBI may be forced to sell some dollars to help shore up the domestic currency. This depletes the domestic Forex reserve.
Q) What is Foreign Direct Investment (FDI)?
Foreign direct investment (FDI) is a category of cross-border investment in which an investor resident in one economy establishes a lasting interest in and a significant degree of influence over an enterprise resident in another economy. Ownership of 10 percent or more of the voting power in an enterprise in one economy by an investor in another economy is evidence of such a relationship. FDI is a key element in international economic integration because it creates stable and long-lasting links between economies.