Story Of The Week

The Federal Reserve Decision & Road Ahead

The much awaited decision of Fed is finally out. The speculations regarding whether Fed will hold rates or increase rates have ended. But that’s not the end to this for now. The guessing game for the investors has begun again on the big question of “When is the hike coming?” This story aims to bring the detailed analysis of how things have panned out till now & what is the present situation.

INTRODUCTION

The Federal Reserve System (informally known as the Fed) is the central banking system of the United States just as RBI is to India. The main functions which come under the purview of Fed are-: to address the problem of banking panics (Recessions), to manage money supply of country through monetary policy with three basic objectives of maximum employment with stable prices (Inflation) & moderate long term interest rates, supervise & regulate banking institutions, protect credit rights of consumers, maintain the stability of the financial markets & strengthen U.S. standing in the world economy.

The Background

The Fed has not increased the interest rates for almost more than a decade. The last rise was in June 2006. Rates have been at zero since late 2008, when they were slashed in the midst of the financial crisis. This had all started from the dot-com bubble in 1997-2000. As a consequence, the interest rates were lowered in order to encourage borrowing. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%. This was done to soften the effects of the collapse of the dot-com bubble and the September 2001 terrorist attacks, as well as to combat a perceived risk of deflation. As early as 2002 it was apparent that credit was fuelling housing instead of business investment as some economists went so far as to advocate that the Fed “needs to create a housing bubble to replace the Nasdaq bubble”. Additional downward pressure on interest rates was created by the high and rising U.S. current account deficit, which peaked along with the housing bubble in 2006. Then Federal Reserve chairman Ben Bernanke explained how trade deficits required the U.S. to borrow money from abroad, in the process raising bond prices and lowering interest rates.

A flood of funds (capital or liquidity) reached the U.S. financial markets. Foreign governments supplied funds by purchasing Treasury bonds and thus avoided much of the direct impact of the crisis. U.S. households, on the other hand, used funds borrowed from foreigners to finance consumption or to bid up the prices of housing and financial assets. Financial institutions invested foreign funds in mortgage-backed securities. When in 2008, the housing bubble collapsed, the Fed took steps to expand money supplies to avoid the risk of a deflationary spiral, in which lower wages and higher unemployment lead to a decline in global consumption. In its effort to try and stimulate the U.S. economy, the Federal Reserve cut its key interest rate to a range between zero and 0.25%. Economist John B. Taylor has asserted that the Fed was responsible, or at least partially responsible, for the United States housing bubble which occurred prior to the 2007 recession. He claims that the Fed kept interest rates too low following the 2001 recession. The housing bubble then led to the credit crunch. Then-Chairman Alan Greenspan disputes his interpretation. He points out that the Fed’s control over the long-term interest rates is only indirect. The Fed did raise the short-term interest rate over which it has control, but the long-term interest rate did not increase.

THE DECISION BY JANET YELLEN & RATIONALE BEHIND

Since then the Fed has held on to the interest rates. But, in the summer of this year the Fed officials signalled that the U.S. economy was improving with expectations of slightly higher gross domestic product and lower unemployment rate & eventually rising inflation. This has created huge anticipation in markets all over the world. But the indications of slowing global economic growth with concerns about sluggish inflation (which is both a sign of economic weakness and an impediment to faster growth), forced Fed Chairman Yellen to hold the rates.

 

 

 

To quote her words “The recovery from the Great Recession has advanced sufficiently far and domestic spending has been sufficiently robust that an argument can be made for a rise in interest rates at this time but, heightened uncertainties abroad including the Chinese economy’s weakness, had persuaded the bank to wait at least a few more weeks for fresh data that might “bolster its confidence” in continued growth”.

IMPACT WORLDWIDE

The concern is that with the Chinese economy already slowing down and developing economies struggling with plunging currencies and low commodity prices the hike can cause a boomerang effect i.e.  The Fed raises rates, that hurt other economies even more, and then economic woes in developing countries eventually hurt U.S. trade and economic growth.

Quoting Diane Swonk, chief economist at Mesirow financial “A rate hike has upsides and downsides. The U.S. economy could gain additional momentum behind home buyers trying to lock in low mortgage rates. The downside risks, however, is that a rate hike adds insult to injury in an uncertain world and causes a moderation in growth”.

Also, so far this year whenever news suggested the Fed might raise rates, global stock markets generally went down, and the opposite happened when economic news suggested a rate hike might be pushed off. The best educated guess in situation of such uncertainty is that a rate hike could cause some market volatility at least in the short term.

IMPACT ON INDIA

The hike in rates will also have an impact on India. FII flows are driven by interest rates movement in the US and other developed economies. No doubt, to that extent India is vulnerable and if there is a sell-off in global equities or emerging markets, we will not be spared as well. But, the positives for India are more than the negatives. As the dust settles down, volatility would ease in the Indian markets & it would definitely attract some fresh capital. Also, the rupee has been as topsy -turvy as the domestic stock market. But experts believe as the global concerns recede, rupee will see some stability. Clubbed with that, any stability in the rupee after the Fed charts the course of future rate hikes can bring in stability to earnings of the export oriented firms.

THE ROAD AHEAD

The Fed has policy meetings slotted in October and December. Also, the Fed has continued to maintain its bias towards a rate hike sometime this year. So, a hike is definitely on the cards with only the timing remaining uncertain.

Federal funds target rate

For U.S., as the Fed raises rates, banks, money-market funds and other savings vehicles are likely to start offering higher returns on safe investments. With that most experts, expect long-term rates to rise in coming years, increasing the cost of homes and cars.

The first rate hike since 2006, won’t be a game changer overnight. But, it will pave the way for more hikes over the next year or two, and rates on all types of things will gradually move up, experts say. Also, the uncertainty in the markets is expected to remain & volatile markets would be the trend in the coming days.

REFERENCES

http://www.nytimes.com/interactive/2015/business/economy/fed-interest-rates.html

http://money.cnn.com/2008/12/16/news/economy/fed_decision/index.htm

http://www.forbes.com/sites/stevedenning/2011/11/22/5086/

http://www.financialexpress.com/article/markets/indian-markets/deferred-us-fed-rate-hike-likely-to-soothe-jittery-investor-nerves-arrest-fii-outflow

http://www.cnbc.com/2015/09/17/fed-leaves-rates-unchanged

http://www.thehindubusinessline.com/economy/global-economy-worries-prompt-fed-to-hold-rates-steady

http://arthveda.co.in/media-coverage/how-us-fed-rate-hike-will-impact-indian-markets-bofa-says-its-a-positive

http://blogs.economictimes.indiatimes.com/et-editorials/fed-rate-hike-the-respite-offered-should-not-be-frittered-away

http://www.reuters.com/article/2015/09/19/usa-fed-williams-global

http://www.livemint.com/Money/How-US-rate-hikes-will-impact-Indian-market.html

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