In December 2021, the Federal Open Market Committee (FOMC) predicted that it would increase the fed rate (which is now set at zero) in the coming year by as much as three times. It gives a graph of its expectations “dot-plot” for analysts to understand how it is thinking.
Jerome Powell and his team of Governors have signaled steps to increase the Fed rates to beat the recession caused by the COVID-19 pandemic in three phases.
Due to the pandemic, inflation in the U.S. is currently at a nearly four-decade high, and the unemployment rate has been picked up but still needs to be strengthened.
As per the Bureau of Labor Statistics (BLS) report, the inflation rate is currently at 7.0%, the highest since June of 1982.
To fight the increased price levels (inflation) and ensure a higher inflow to its economy, the Fed is likely to increase the interest rates.
The Fed’s tactics to fight high inflation could possibly remove hundreds of billions of dollars of liquidity from other investable markets.
The increase in interest rates in the U.S. could affect both developed and emerging markets and here are some of our observations.
Impact of Fed Rate on Emerging Markets
The rising interest rates in the U.S. are often considered a signal of outflow for emerging market economies (EMEs) as they have high macroeconomic vulnerabilities.
The rising interest rates cause an increase in debt burdens, capital outflows, and currency depreciation, ultimately causing a tight financial situation.
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Countries with high dollar-denominated debt could find it more expensive going forward to service it. There is a high danger of poor countries falling into debt distress as they will be unable to pay back the dollar loans.
Further, emerging markets that have high inflation rates and have weaker institutions will have to pay more attention to their policies and may also have to raise benchmark interest rates.
The global debt is already touching $226 trillion owing to the pandemic-led recession. The Fed rate increase will only add fuel to the fire of debt which many countries will find tough to fight.
Will Other Developed Countries Follow Suit?
If the interest rates are increased in the U.S., then it is likely that other developed nations influenced by the U.S. will also increase their interest rates.
Although the incentive to raise interest rates is logically bound to follow, the Bank of Japan plans to follow its own inflationary policy. Even though the Euro’s inflation hit 5%, one of the highest in 2021, the European Central Bank’s stance to increase its rate seems plausible in the coming few months as well.
Most other developed countries are waiting and watching the domestic demand to regain and then see the effect of inflation before they take a firm stance on increasing their rates.
Effect on the Indian Bond Market
The increasing interest rates in the U.S. will definitely impact all the emerging countries, including India, and will affect India’s stock and bond market.
- The interest rates increase in the U.S treasuries will surely see an outflow from Indian markets to a more steady T-Bills.
- A higher U.S. interest rate will cause depreciation of the Rupee against the Dollar. This means foreign investors will earn fewer returns, so they will take out their money from India.
- To add to this, the Reserve Bank of India will also probably increase the interest rates in India as the spread between U.S. and Indian government bonds will narrow.
- The increases in interest rates in India may cause the bond prices to fall and make an investment in existing bonds unattractive while creating losses for bondholders.