What Happens When The US Federal Reserve Raises Interest Rates In The US?

In what did not come in as a surprise, the US central bank, Federal Reserve has raised its interest rate by 75 bps, following the FOMC meeting.

In the FOMC statement, the US Federal Reserve stated that, "The Committee seeks to achieve maximum employment and inflation at the rate of 2% over the longer run. In support of these goals, the Committee decided to raise the target range for the federal funds rate to 3-3/4 to 4%. The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2% over time."

Impact of US Fed interest rate hikes on emerging market economies like India

The impact of the US Fed hike on emerging economies like India could be limited, though sometimes it could be worrisome. The one thing that does happen is that there could be capital outflows, particularly from the stock markets, through Foreign Portfolio Investors.

The impact of this is felt on the currency market as well. This leads to the Indian rupee falling against the US Dollar, as rise in interest rates by the US Fed tends to strengthen the dollar against a basket of currencies. Apart from this, there could be impact on exports, particularly IT exports. Since Indian companies like TCS, Infosys, HCL Tech, Tech Mahindra and scores of other companies provide IT services, they could be impacted as American companies cut down on spending on fears of impending recession in the case of rising interest rates.

In short, the rupee depreciates, there tends to be capital outflows and exports could be hit on fears of recession. In fact, the rupee plunged recently by 60 paise to record low levels of 83 for the first time against the US dollar on unabated foreign capital outflows and a strong dollar in the overseas markets.

Impact of US Fed interest rate hikes on the stock markets

When the US Federal Reserve raises interest rates rise, bond yields rise, which tends to push stock markets lower. When investors get higher interest rates on fixed interest bearing instruments, they tend to dump stocks. These days the markets anticipate well in advance and hence the reaction in the stock markets is not as sharp on the day the US Fed hikes rates. However, if the tone of the US Fed does sound hawkish, the markets tend to react sharply on the lower side. Following Wednesday's rise in interest rates, the Dow Jones plunged and Asian markets are expected to follow as there are worries that there could be further interest rate increases, though not sharper. So, emerging market stocks, where Foreign Portfolio Investors have invested large amounts tend to be impacted.

Sometimes the global markets already price in, the rates hikes, so the price damage in stocks is limited on the day of the announcement. Markets always tend to discount things in the immediate future.

Fixed interest bearing instruments tend to see hike in interest rates

Fixed interest bearing instruments see increase in interest rates like savings accounts and certificate of deposits. However, this is more restricted to the US economy more than others, though sometimes other central banks follow the US Fed and hike interest rates. On the other hand, mortgages in the US tend to see interest rates rising. This in turn leads to lower housing and mortgage loan growth. The impact is also felt on auto loans and in short individuals curb spending. This in turn could lead to a recession.

Gold prices tend to fall

As interest rates are driven higher by the US Federal Reserve, bond yields rise. When bond yields in the US rise, they tend to lead to a fall in commodities like Gold, as investors move away from safe haven gold, to sovereign bonds, which are very safe. Gold prices thus tend to fall, in a rising interest rate scenario.