Explainer: Things you need to know about Federal Reserve Funds Rate

Recent US inflation concerns have been stoked by President Joe Biden’s $2 trillion stimulus package. From food to lumber to gasoline, US prices on a broad range of essential goods are up.

Adding to the worry, the US added only 266,000 jobs in April, far fewer than expected. In comparison, the US economy had managed to add 770,000 jobs in March 2021.

Federal Reserve Chairman Jerome Powell had already indicated a temporary higher inflation rate would be there as the world gets back to normal.

On Tuesday, the US Federal Open Market Committee (FOMC) end-of-April minutes of meeting is released. In the minutes of the central bank’s April policy meet, some officials said it might be appropriate at some point in the future meetings to start discussing a plan to ease up Fed’s massive bond-buying program.

Federal Reserve Chairman Jerome Powell has said that economic recovery in the nation is “uneven and far from complete.”

Mr Jerome also added that the economy was still not showing the “substantial further progress” on benchmarks that the committee expected like nearly full employment and an inflation rate of slightly higher than 2 per cent, the report added.

As per minutes of FOMC and the economic condition of the US, Experts are expecting that the Federal Reserve will increase the federal funds rate, which will have ripple effects on emerging markets.

What Is the Federal Funds Rate?

The federal funds rate is the target interest rate decided by the Federal Open Market Committee (FOMC) at which commercial banks borrow and lend their reserves (Cash) to each other overnight. By law, banks must maintain a reserve equal to a certain percentage of their deposits in an account at a Federal Reserve bank. It is similar to RBI rates where RBI decides Repo, Reverse Repo, CRR and SLR rates.

Impacts of the Federal Funds Rate
The federal funds rate is one of the most important interest rates in the US economy since it affects monetary and financial conditions, which in turn have a bearing on critical aspects of the broader economy including employment, growth, and inflation.

After the FOMC meeting, investors are keeping a close watch on the federal funds rate. The stock market reacts very strongly to changes in the federal funds rate. As expecting the federal reserve rate may increase, it can lead the market down as the cost of borrowing will get higher. Experts are paying attention to the statement by FOMC to try to get a sense of where the target rate might be headed.

What will be the impact on emerging economies, including India?

Theoretically, a rate cut in the US puts a positive impact on emerging market economies, especially from a debt market perspective. FIIs borrow money from the US at low-interest rates in dollars terms and invest that money in bonds of emerging countries like India in rupee terms to earn a higher rate of interest. Similarly, the rate hike would be negative for emerging market economies, as borrowing money from the US would be expensive for FIIs and the margin between borrowing and lending will decrease.

What will be the impact on Indian equities?

US rate hike is the ultimate barometer of risk worldwide. If the rate goes up, people and FIIs become cautious. If the Fed rate goes up then FIIs may sell their holding in the Indian equity market which will lead the market to decline.

What will be the impact on bonds?

The hikes will lead to a growth in yields on US treasuries and a stronger dollar. The rise in the Fed rate narrows the rate differential between the US and India, making Indian bonds less attractive for foreign portfolio investors. The 10-year Treasury yield rose from 1.64 per cent on Wednesday to 1.7 per cent on Thursday. This will reduce furthermore if foreign portfolio investors (FPIs) hedge their investments.

How will the rupee react?

The Fed rate hike in the US will lead to a stronger dollar and a weaker rupee, which will reduce investment returns for foreign institutional investors and prompt them to sell. Firms that have borrowed heavily in dollars in the overseas market may see higher cost on borrowings as they have to pay more to borrowers if the price of the rupee fell.

Will it affect monetary policy in India?

India has an independent monetary policy committee tasked with maintaining retail inflation in a certain band. Rupee depreciation resulting from a US rate hike can lead to higher imported inflation. A monetary action in the US affects global financial and liquidity conditions. These, in turn, determine foreign flows into emerging markets such as India. Hence, a Fed rate hike is an important variable for monetary policy decision in India. However, India can afford to wait