The latest policy gathering of the US Federal Reserve, which concluded with no changes to the policy rate, retaining it at 5.25%, has incited discussions about India’s interest rates and markets. Despite retaining the current state, the Federal Reserve suggested two more rate hikes on the horizon for this year, aimed to curb inflation, pushing the rate to 6% by the end of 2023.
How Fed’s Policy Influence Indian Market?
Following the outcome of the Federal Reserve policy gathering, the Indian markets suffered a 0.49% loss on June 29, 2023. The Federal Reserve’s decisions tend to reverberate in Indian markets via several key channels:
Exchange Rate Channel
Rate hikes by the Federal Reserve poise the US dollar for strength against other currencies, including the Indian Rupee, causing it to weaken. For those in India who have availed loans in foreign currency, this weakening of the rupee results in a spike in their debt servicing costs.
Capital Flow Channel
An increase in the Federal Reserve’s rates narrows the interest rate differential between India and the US, making India less inviting for foreign investors pursuing higher returns. This could lead to capital outflows from India’s equity and debt markets, devaluing assets and promoting market volatility. Such capital outflows might also deplete India’s foreign exchange reserves and lead to liquidity shortages in domestic markets.
Inflation Channel
Federal Reserve-induced rate hikes could also manipulate India’s inflation in a couple of ways. First, a depreciated rupee can cause imported inflation to rise in India by boosting the prices of imports like oil, gold, and electronics. Second, an upswing in global commodity prices triggered by robust US demand could increase India’s domestic inflation, affecting input costs across sectors like agriculture, manufacturing, and services.
Growth Channel
Federal Reserve’s rate hikes may affect India’s economic growth as well. Firstly, a rigid US monetary policy could slow down global economic recuperation from the pandemic, consequently damaging India’s export prospects and external demand. Secondly, higher domestic interest rates brought about by capital outflows and inflationary pressures are likely to suppress India’s domestic demand and investment activities.
What Could be the Possible Scenarios for Indian Markets?
Best-case Scenario
In the best-case scenario, the Federal Reserve’s rate hike is persistent but reasonable and comes with transparent and trustworthy communication. The RBI (Reserve Bank of India) retains a supportive stance, ensuring liquidity and credit conditions in India. Here, India’s economic recovery is hearty and resilient, backed by vigorous domestic and external demand. India’s inflation remains contained and manageable, with fiscal and current account deficits under control. The global market displays a high-risk appetite, and foreign investors retain their positive outlook on India’s growth potential and reforms.
Worst-case Scenario
The worst-case scenario would involve abrupt and aggressive rate hikes by the Federal Reserve, triggered by unforeseen inflation shocks. In such a case, an unexpected tightening of policies could force the RBI to defend the rupee and control inflation. India’s economic recovery could become weak and uneven due to pandemic-related uncertainties and structural bottlenecks. High and persistent inflation coupled with unsustainable fiscal and current account deficits could create an environment of low global risk appetite, leading to foreign investors fleeing India’s market due to policy uncertainty, geopolitical tensions, and governance issues.
The impact of the Federal Reserve’s policies emphasizes the interconnection and influence between global and national markets. This phenomenon often requires other nations like India to navigate through these international economic changes carefully noting that their economic well-being often lies in the balance.
