What may happen when US Federal Reserve raises its benchmark interest rate again in June?

17 May 2022 , 03:21 PM

Another 50 basis point hike by the US Federal Reserve in Federal Funds rate is expected in June. One basis point is .01%.  Federal Funds rate is the minimum rate that US banks can charge each other for short term loans. So increase in federal funds rate will also increase the cost of borrowing for borrowers.

Besides this the Federal Reserve has also said that it will reduce its balance sheet by around $95 billion per month. Reduction in balance sheet means that it will sell the Treasury bonds that it owns and draw money out from the market in the process. When Federal Reserve sells treasury bonds, investors who buy the bonds pay it. Money therefore moves from the market to the central bank. This results in reduction in money supply. Reduction in money supply will put further upward pressure on cost of borrowing in US. Cost of borrowing will go up. US Federal Reserve is doing all this in order to bring down rising inflation. US Inflation rate is currently 8.6%. This is an alarmingly high inflation rate for a rich and developed country, whose target inflation rate is around 2%.

Increase in cost of borrowing in US is not a good news for Indian equity markets. A lot of foreign investment that comes into Indian equity markets is because foreign investors are able to raise money cheaply in US. They then invest this money in Indian equity markets to get higher returns. Higher interest rate will also increase returns of US assets such as bonds. This means that investors may find it more attractive to invest in US financial assets than in financial assets of India and other countries.

Rise in US interest rate will also make Indian rupee depreciate against the US dollar, if India does not increase its interest rate every time the US Federal Reserve increases it. But increasing interest rate by too much will slow down recovery of Indian economy.  With general elections less than 2 years away, Indian government would not like to go down into elections with an economy in slowdown.
Overall, it is like a near — jam scenario in equity markets in the foreseeable future, including in the Indian market.  What can bring some hope and joy is some sudden, unforeseeable positive shock. Like a sudden ending of the war in Ukraine.