Macroeconomic uncertainty and rising interest rates.

Fed has increased the fed fund rates multiple times this year and now at 4.25 – 4.5%, the rate is highest in 15 years.

What is fed fund rate?
This is the rate at which one bank lends to another on an overnight basis.

Why fed is increasing rates?
During the start of COVID, fed decided to arrest the potential COVID induced slowdown by printing money.

The money equation says:

Money Supply*Velocity of money = Nominal GDP (Price * Real GDP)

In short term real GDP cannot increase unless we make substantial improvement at the supply side of the economics and expand capacity which is very difficult in the short term. Velocity of money is a behavioral variable which is fairly constant in short term. Now that means money supply has direct bearing on the price levels prevailing in a economy and sustained increase in the price levels in the economy is called inflation.

Central banks world over are following inflation targeting regime where they try to control inflation by monetary tightening i.e., reducing the money supply which is achieved by increasing interest rates.

Has fed been successful so far?
Fed has increased the funds rate seven times this year and the latest increase being 50 bps (last four were 75 bps). Retail inflation although came down to 7.1% from the highs of 9.1% in June but it is still far away from the Fed’s target of 2% which means this is not the end of hawkish stance of federal reserve. It will continue to increase rates and is projected to reach 5.1%.

Now the concerning fact is US unemployment rate is at historical lows which has led to the wage inflation. Increase in rates will discourage firms from expanding and create jobs. We can correlate this with the recent layoffs that have been happening in the tech companies. Please note that number of employees are still higher than pre-COVID phase at these companies.

Higher fed rates and Indian economy – This leads to movement of investor’s money to US to benefit from higher interest rates (hot money). While this will definitely have an impact on stock markets, more severe would be the impact through deteriorating exchange rate and hence increase in imported inflation which RBI might tackle with higher repo rates and hence might take India down the growth trajectory.

Take a listen to the video where I asked the question the then IMF chief economist about a year ago.