Context: The decision of U.S federal reserve to increase interest rates by 2023 will have a significant impact on India. It may depreciate the Indian rupee and increase the inflation levels in the country thereby demanding robust reforms.
Why is Fed Policy important?
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Any interest rate change in the U.S influences exchange rates, international money flows and, to a certain extent, interest rates the world over.
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The implications are very wide as the US is the world’s largest economy and the dollar is the most traded currency.
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When the US Fed raises rates, foreign institutional investors (FIIs) of American origin and other large foreign funds move back to the US in search of better returns.
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When FIIs withdraw money from the host country, it negatively influences the exchange rate. This results in depreciation of the host country’s currency and resulting in appreciation of the dollar.
What is its link with the Indian economy?
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Given that India is a growing economy offering higher returns, there exists a strong link between changes in Fed rate and FII flows.
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A Fed rate change leads to fluctuations in Indian capital markets and impacts exchange rate. With the US Fed hinting at two rate hikes by 2023, Indian stocks and currency have been adversely impacted.
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Rupee depreciation can lead to higher import prices, and with crude oil being the largest component of Indian imports, it could lead to increased fuel prices, worsening the cost-push inflation.
Thus, the government should strive for economic revival and initiate reforms, and build on India’s story of being an attractive destination for investors.