What Does the US Fed's Biggest Rate Hike Mean?

Introduction

When America sneezes, the rest of the world catches a flu. If you've noticed a sharp selloff in the stock market over the last two days, it is due to the US Federal Reserve's latest announcement on interest rates. The Fed, America’s central bank, hiked interest rates by 75 basis points or 0.75%. It was a policy response against consumer price inflation that hit a 40-year high.

The rate hike is the biggest in 28 years. The last time the Fed raised interest rates by 75 basis points was in November 1994. While the hike is what the market and experts expected, it still delivered a blow to stock markets worldwide. 

Why did the Federal Reserve hike interest rates? 

Financial markets were flooded with ‘easy’ money. Central banks pushed up liquidity in the financial system to tackle economic slowdowns. Cheap money meant better credit growth and faster economic growth. However, that does not work if the consumer price inflation soars. The era of ‘easy’ money is over.

Hiking interest rates is one of the most effective ways to curb inflation. Worldwide, inflation has been on a steep rise because of multiple factors. One is the Covid-19 pandemic, which wreaked havoc on supply chains and prices of goods globally. The Russia-Ukraine war is now exacerbating problems supply side problems.

The US is witnessing an inflation rate that is the highest in 40 years. The price of consumer goods has shot up, putting pressure on household budgets. And inflation does not seem to be slowing down. 

In a bid to control inflation, the Fed hiked interest rates steeply. When the central bank of a country increases interest rates, it makes borrowing more costly. As a result, people spend less. This reduces the demand for goods and services, eventually bringing down prices. 

How will it affect the Indian economy? 

Fed interest rate hikes are never good news for the Indian economy. We can expect negative consequences such as further currency depreciation and an inflationary situation. Here are some implications of the US Fed rate hike on the Indian economy: 

1. Tight financials 

A rising interest rate scenario in the US triggers a risk-off investment strategy. It strengthens the US dollar and assets denominated in that currency. As a result, emerging markets such as India will witness an outflow of foreign capital. India is already seeing foreign capital outflow, and the Fed's interest rate hike will only make it more pronounced. This means a tighter financial situation for India in the coming months. 

2. Weaker rupee 

As money flows out of the Indian economy and into the US, the American dollar will grow stronger against the rupee. As a result, we can expect the Indian rupee to depreciate. The rupee is already at an all-time low against the dollar, closing at 78.17 per dollar. We can expect a further strain on the value of the rupee. 

3. Rising inflation 

While the Federal Reserve's rate hike might be able to curb inflation in the US, the opposite is likely to happen in India. As the cost of imports becomes more expensive because of a weakening rupee, the price of goods in the country will shoot up. Expect a high inflationary scenario in the country. 

What should investors do? 

As such, while investing, you should be mindful of investments that will help you stay ahead of inflation. 

Stock market investments may not sound like a good idea as markets across the world tank, but history shows that long-term investment in strong companies can give returns good enough to comfortably beat inflation.

It may be a good idea to spend time on research and identify companies that can pass on high input costs to consumers. They tend to do better when inflation is high. Gold can also be a hedge against inflation. Consider investing in digital gold, RBI gold bonds and other instruments like exchange-traded funds. 

Additional read: How to Beat Inflation with Your Investment?

What is the rest of the world up to? 

Following the US's footsteps, the UK and Switzerland have also hiked interest rates. The UK has hiked interest rates by 25 basis points. Switzerland's interest rate hike from minus 0.75% to minus 0.25% is the first hike in 15 years.  

This means that countries worldwide are trying to tackle inflation and a global slowdown is around the corner. 

The Fed's interest rate hike in a bid to curb inflation can have severe consequences on the Indian economy. As an investor, you should focus on reducing your borrowings and investing in avenues that are a hedge against inflation.