IMPACT OF HIGHER
INTEREST RATE IN US - ECONOMY
News: India to face most impact if
high U.S. interest rates persist
What's in the news?
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A ‘higher for longer’ interest rate scenario, under
which the U.S. Federal Reserve and the European Central Bank defer anticipated
rate cuts to beyond 2024, would impact emerging economies’ currencies as well
as growth and inflation outlooks, with India likely to see the most pronounced
effects among Asian countries, as per an Asian Development Bank simulation.
Federal Reserve:
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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.
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It provides the country with a safe, flexible, and
stable monetary and financial system.
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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.
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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:
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The US Fed is the world's most powerful central bank.
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When the Fed adjusts interest rates, the effects
are felt worldwide, influencing both
developed and emerging economies.
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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.
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In such a scenario, capital-intensive sectors,
which heavily rely on Foreign Direct Investments (FDIs), could be the first to
feel the impact.
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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:
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After a rate hike by the US Fed, the difference
between interest rates in US and India shrinks, which affects the currency trade negatively.
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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.
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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.
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India might have to increase its own interest rates
to manage inflation and prevent
further depreciation of the rupee, which could have its own set of consequences on the domestic economy.
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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 safeguard the rupee.
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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.
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As per ADB’s projections, India’s GDP growth may
slow slightly (by under 0.2 percentage points in 2025) compared to baseline
projections. This is partly due to increased
costs of borrowing and investments, as global capital shifts towards higher
yielding U.S. assets, reducing the amount of foreign investment flowing into
emerging markets like India.
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The depreciation of the rupee directly affects India’s imports, increasing the
prices of imported goods, particularly oil and other commodities that are
crucial for India’s economy.
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On the positive side, a weaker rupee could make Indian exports more competitive on the
global market, potentially boosting export volumes. This could add about 0.05
percentage points to India’s GDP growth this year.
○ However, this effect might reverse in 2025 and 2026 as global monetary conditions stabilize and the rupee potentially strengthens, making exports less competitive again.