You know what I have noticed about the world economy? Nobody panics when things go “according to the Fed.” Even if the Fed is horrifying .If tomorrow I tell the RBI that, Indian exports will get short or F.D.I. in India will be blown up, nobody panics because it’s all part of the Fed’s plan. But when I say that an insignificant rate known as the Fed Rate will be dropped, everyone loses their minds.
WHAT WE KNOW IS WHAT WE HAVE LEARNT
The central bank of every country requires its (lovely) commercial banks to keep a minimum ratio of reserves they have with it. (Economics enthusiasts call it Cash Reserve Ratio).Banks are legally required to keep that minimum proportion of reserves with the Fed for which they are allowed to borrow funds (if they are short) from other banks (which have a surplus).
Fed Rate, more popularly criticised as Federal funds rate is the interest rate at which banks which have surplus reserves lend money to other banks to curb the shortfall.
The current Fed Rate is 0.25-0.50. It means that if reserve requirements are 20 crores. And Bank A has 18. Bank B which has 22 can come to the rescue and lend its surplus 2 crores to Bank A at any interest rate between 0.25-0.5 %
HOW DOES IT MOVE THE ECONOMY?
The Fed, when it sees that new jobs have been created or when (fake) income numbers direct that there is a phenomenal rise in consumption, then it raises the Fed rate to keep inflation in check. An increase in Fed rate makes it unlikely for Bank B to be short on funds as it doesn’t want to pay high interest to Bank A. Hence it keeps its fair share of reserves. For that, it lends the lesser amount of funds to the general public and the people who have been taking loans can’t do so without paying a higher interest rate.
But when iPhone sales drop or Jim Rogers comes from his cave to say that Recession is coming, The Fed reduces the rate to make it easy for people to borrow and buy.
HOW DOES IT AFFECT US?
The Markets: Since an increase in rate hike means higher interest rates, the (lavish) corporations in U.S. can’t get easy money which takes a toll on the Indian stock markets which are governed by American portfolio investments. A fall in Fed rate is worse as it means that the world’s biggest economy is nearing recession which has an impact on every market you can think about.
Currency: Due to a fall in foreign inflows in India, the supply of U.S. Dollar reduces which takes a toll on I.N.R. It enters a free-fall mode, things get costlier, exports rise and Raghuram Rajan does what he does.( sell some dollars from the RBI reserves)
U.S. inflation barely rose in March as consumer spending remained tepid, making it less likely that the Federal Reserve will be able to follow through on its projected two Fed rate increases this year. The Fed after its meeting on April 29 said it was continuing to “closely” monitor inflation. It left its cherished rate unchanged and suggested it was in no hurry to tighten monetary policy further.
Well, the way US economy is fairing this year, it is tough to say if we will see a rate hike. But even if it doesn’t happen, the volatility will continue jolting the markets and our ET app. Analysts will keep on earning by deciphering the cryptic words of the Fed. And the Fed will keep on haunting us with the Fed rate.
“The Fed’s morals. It’s code. It’s a bad joke. Dropped at the first signs of inflation.”
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Views presented in the article are those of the author and not of ED.