US Fed Interest Rate Hike [UPSC Current Affairs]

In March 2023, the US Federal Reserve hiked interest rates by a quarter of a percentage point. In this context, it is important to understand what is the Federal Reserve of the US, and the impact of its rate hike on various entities. This is an important topic for the IAS exam economy section.

What is the Federal Reserve?

The Federal Reserve (also known as the Fed) is the central banking system of the United States, established in 1913 through the Federal Reserve Act to address financial crises and promote economic stability.

• The Fed is made up of a Board of Governors in Washington, D.C., and 12 regional Federal Reserve Banks located in major cities throughout the country.
• The Fed’s primary responsibilities include conducting monetary policy to promote price stability and full employment, supervising and regulating banks and other financial institutions, and providing financial services to the U.S. government and other banks. 
• To carry out its monetary policy objectives, the Fed uses various tools, including setting interest rates, open market operations, and adjusting reserve requirements for banks.
• The Federal Reserve also plays a crucial role in the U.S. financial system by serving as a lender of last resort during times of financial crisis. This means that the Fed can provide loans and liquidity to financial institutions that are experiencing short-term funding problems, which can help prevent broader financial instability.

US Fed Interest Rate Hike Impact

Impact on Asset Prices:

• One of the immediate effects of an increase in interest rates is the discounting of asset prices at a higher rate. 
• When interest rates rise, investors demand higher rates of return on their assets, causing prices to drop. 
• Even U.S. Treasury securities, which are considered the safest assets globally, are not immune to interest rate increases. 
• Investors holding U.S. 10-year and 30-year Treasury securities face significant unrealized losses due to rising interest rates.

Impact on Banks:

• The decline in asset prices has resulted in the collapse of Silicon Valley Bank and Signature Bank. 
• SVB had 55% of its assets in securities and was facing an unrealized loss of over $18 billion, leading to severe trouble and risking collapse. This situation is similar to a six-foot man drowning while crossing a stream that was five feet deep on average. 
• U.S. Treasury securities are safe assets to hold, but no asset is risk-free, and one should always consider unlikely scenarios that could wipe out their holdings.

Impact on India:

• In order to mitigate spillover effects, the Reserve Bank of India (RBI) must increase interest rates in line with the Federal Reserve. 
• A significant disparity in interest rates could lead to currency depreciation, resulting in higher import costs and inflation. India must address its inflation problem by raising interest rates, regardless of the Federal Reserve’s actions. 
• Banks must increase their lending rates to maintain their net interest margin in line with the RBI. 
• In keeping with the RBI’s policy, the State Bank of India has raised its housing loan rate to 8.5% as of March 2023 from a low of 6.75% in 2021.

Impact on Borrowers:

• The rise in interest rates implies that people with EMIs may find it challenging to maintain their standard of living, as it indicates wage cuts and possible job losses.
• Loans and EMIs alone do not guarantee a better quality of life for salaried individuals.
• To manage financial difficulties, it is essential to live within one’s means, build a nest egg by investing in the stock market, and pay off EMIs without incurring further debt.

Positive Real Rates and Inflation:

• According to some economists, positive real rates are necessary to effectively address inflation.
• Despite a steady decline in inflation rates from 9% to 6% in the past year, persistent inflation highlights that the Federal Reserve needs to take further measures to increase rates.

Conclusion:

• The Federal Reserve’s hawkish stance on interest rates has far-reaching impacts on the economy, affecting asset prices, banks, and borrowers. While rate hikes are necessary to tackle inflation, it is crucial to consider the unintended consequences and prepare accordingly.

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