Fed interest rate hike - What does it mean?

22 Sep 2022 , 11:50 AM

Yesterday evening, US Federal Reserve increased its benchmark interest rate by another 75 basis points or 0.75%. This is the third consecutive interest rate hike that the US central bank has done this year. It further indicated that one more 75 basis point hike will be done before the end of this year. The Federal Reserve also indicated that it will not mind a moderate recession for controlling inflation. 

Increase in interest rates will slow down interest sensitive consumption and investment in United States. By slowing down this interest sensitive investment and consumption, the US central bank intends to bring down overall demand in the economy. By bringing down demand in the economy, it intends to slow down price rise or inflation. Inflation rate in United States stood at 8.3% in August. 

A slowdown in US economy will bring slowdown in other economies too. US is one of the biggest importers of goods and services from countries around the world. Exports of countries such as India will be adversely impacted because of a prolonged economic slowdown or recession in United States.

Raising of interest rate also means increasing the cost of money in US. Foreign Investors based in US will therefore demand a higher return from their equity investments in countries such as India. Many of them will pull some of their money out of these markets by selling their investments. This will create selling pressure in these equity markets. Many of them will see declining trend over the next few days.

The bigger question is, Is Federal Reserve pursuing the right course? The current high inflation in US is mainly caused by two years of supply chain disruptions, operational disruptions, and labor market disruptions caused by Covid lockdowns. The situation was further exacerbated by disruptions caused by Ukraine war. Raising of interest rates for controlling inflation is effective when inflation is caused by demand side factors like sudden increase in demand. This policy measure is not effective when inflation is caused by reduction in supply or supply side factors. When interest sensitive investment becomes more expensive and interest sensitive consumption goes down at the same time, supply can get reduced further.  This can have the impact of further increasing inflation rather than slowing it down. 

Federal Reserve’s hawkish stand may end up bringing recession in US economy without having any significant positive impact on lowering inflation.  The right course for Federal Reserve would have been to go for more moderate interest rate hikes that do not slow down the economy.