Why should India care if the US central bank cuts interest rates?

Central banks world over have been traditionally focusing on tools such as interest rates to adjust the supply of money as they work towards a goal of sustained economic growth. When interest rates are adjusted, banks, consumers, and borrowers may alter their behaviour in response. The way that rate adjustments motivate such behaviour is known as the interest rate effect. Generally, when interest rates are set by a nation’s central bank, consumer banks extend similar interest rates to their clients.

When interest rates rise, it becomes more “expensive” to borrow money and borrowing costs rise. As a result, consumers are less likely to buy things and businesses are less likely to put money in capital investment. These two sectors diminish under higher interest rates and therefore demand decreases. This reduced level of economic activity leads to lower inflation because lower demand usually means lower prices. High interest rates normally lead to an appreciation of the currency, as foreign investors seek higher returns and increase their demand for the currency. Due to appreciation of home currency, exports are reduced as they become more expensive, and imports rise as they become cheaper. In turn, GDP shrinks.

When interest rates fall, the opposite happens. Businesses and individuals are able to borrow money at affordable rates. This borrowed money leads to increased consumer expenditure and capital investment by businesses and aggregate demand accordingly rises. This leads to higher inflation because higher demand usually means higher prices. Low interest rates normally lead to depreciation of the currency as foreign investors seek higher returns in other countries where interest rates are higher. They sell their home currency in order to buy the foreign currency. A depreciated home currency is generally good for exports and discourages imports as they become more expensive.

 

Why Fed is doing what it is doing?

The US Federal Reserve (Fed) just cut rates for the first time in 4 years and everyone is talking about it. But the question is why would change in US interest rates impact us? Let us understand that in some context first.

We all know that the Covid pandemic impacted every economy and business negatively. Even the US was not spared. The US unemployment rate jumped to 14.7%. To counter the economic disruption and a recession experienced in the wake of the Covid-19 pandemic, the Fed delivered two huge rate cuts at unscheduled emergency meetings in March 2020, returning the federal funds target rate range of zero to 0.25%.

While the US economy was technically growing again by May 2020, after the shortest recession on record, but the US supply chains remained disrupted, and we know from the basic economic fundamentals that when the supply is less, prices rise. And that is what exactly happened. Later, as people started getting out of their homes, the demand for goods and services soared but there was still not enough supply to go around and that drove prices even higher.

Meanwhile, the US government came out with massive support programs during the pandemic and pumped about $5 trillion into the economy. With all this extra cash, people and businesses had more money to spend, which sent demand through the roof. There weren’t enough workers to fill all the open jobs, and this made things worse. Between mid-2021 and early 2022, the number of US job openings doubled compared to unemployed workers. To attract employees, companies had to offer higher wages. And more money in the pocket meant more demand which drove up the cost of goods and services all over again. New supply shocks also appeared as Russia's invasion of Ukraine led to a sharp increase in energy and commodity prices. So, it was no surprise that US inflation skyrocketed and hit a 40-year high of 9.1% in mid-2022. People started feeling the pinch, and the US Fed had to step in. The central bank decided to increase interest rates to make borrowing more expensive. This way, people and businesses will spend less, and inflation will cool down. Fed raised interest rates 11 times in 2022 and 2023, to cool things down.

But as mentioned earlier higher rates also mean borrowing costs go up for companies, leading to cost-cutting, slower expansion, layoffs and less hiring. So as a side effect of the rate hikes, US unemployment, which had hit 3.4% in January 2023 - lowest since 1969, started moving up. So, last year, the Fed hit pause on raising rates further and kept them steady instead. Until just a few days ago, when it finally decided to cut them. And it’s all thanks to unemployment again. Because US unemployment had climbed up nearly 1% reaching 4.2%. Fears of recession in US gripped the financial markets. So, to prevent a bigger slowdown, the Fed cut rates by 0.5%.

But the question is “Why should India care if the US central bank cuts interest rates?”

The US plays a huge role in the global economy, and central banks everywhere keep a close eye on its moves to shape their own economic strategies. There’s an old saying, “When the US sneezes, the world catches a cold.” So, the Fed’s actions, like interest rate cuts, can ripple through other economies.

Lower US rates can make investing in countries like India more attractive. This strategy is known as carry trade, where investors borrow money in the US (where rates are low) and invest it where rates are higher, making a profit on the difference. With more dollars circulating, the value of the dollar drops compared to other currencies. This could lead to more capital flowing into markets like India -be it in stocks, debt, or in the form of foreign direct investment (FDI).

A cut in US interest rate also makes it cheaper for Indian companies to repay loans taken in US dollars. For example, let’s assume that an Indian company took a $100 loan when $1 was worth ₹85. If a rate cut weakens the dollar to ₹84, then repaying a $100 loan becomes cheaper from ₹8500 to ₹8400. While a depreciated dollar or an appreciated home currency (Indian rupee) makes payment for imports of various commodities cheaper for the Indian companies but it can have adverse impact on export competitiveness and also leads to reduced export revenue.

There is also an impact on crude oil. A barrel of oil is priced in U.S. dollars across the world. When the US cuts interest rates, the dollar weakens, it becomes relatively more affordable to purchase oil and attracts more global buyers, which in turn drives up crude prices. For a country like India, which relies heavily on oil imports, it could mean paying a lot more for its energy needs. This could even push up inflation in India making everything from fuel to groceries more expensive.

That puts India and other emerging economies in a complex situation, especially with the US Fed hinting at more rate cuts in the coming months — up to six more times until 2025 – to bring them down to around 3% to 3.5% from the current 4.75% to 5% range. And one should not forget the vicious cycle that lowering rates might start again. It may help with unemployment in the US, but it can also push inflation higher all over again.

So, for the central banks across the globe, it is forever a tricky balancing act and for emerging economies like India the task of maintaining price stability along with other economic development goals becomes even more challenging.