Understanding the role of the US Federal Reserve – II By Dr. Bobby Srinivasan and Dr. Sudhakar Balachandran

June 6, 2016 | Posted by bobbysrinivasan << back to blog

This is an ongoing conversation between the student and his professor.

Student: Now I am keen to know about the impact of the US Federal Reserve on the Indian economy.

Professor: This indeed is a very complex and important question. The open market committee reports can be broadly categorized in to the following,

a) The open market statement sounds hawkish. This means that they are basically threatening the financial market with higher interest rate.

b) Alternately it sounds dovish. This is a signal saying “don’t worry be peaceful for the next 45 days we are not pushing up the interest rate”.

c) You had it good so far we are moving up the fed funds rate by say 25 basis points.

The reactions to these statements affect the Indian stock market commodity prices and the interest as well.

Recently Dr. Rajan of RBI approached the US Fed requesting them not to act unilaterally but also look at the emerging market growth challenges.

Student: Sounds interesting. Can you expand on what you just said.

Professor: Simple. If the US pushes up the discount rate and we don’t adjust the repo rate accordingly the value of rupee comes under pressure. You see as the US interest rate goes up money rushes to the US dollar and pushing its exchange rate higher. Next, if the US pushes up interest rate the US stock market literally shakes and the drop in the Dow Jones has an impact on our Sensex. There is a negative correlation between gold price and US interest rate hike.

Student: I need a little more clarity.

Professor: Sure. Emerging markets such as India has poor savings amount (not the savings rate) currently we have the gross domestic savings rate at 30% of an economy that is around $ 2 trillion US dollars. We receive another 70 to 80 billion dollars as FDI. If the US interest rates go up, the FDI is likely to reduce and this will have an impact on our economy. Let me tell you something interesting. The last 3 Fed Chairman namely Dr. Alan Greenspan, Dr. Ben Bernanke and the current Dr. Janet Yellen were mostly market friendly.

There was a fed chairman during the Presidency of Jimmy Carter by the name Dr. Paul Volcker. During his time there was double digit inflation in the US. Paul Volcker pushed up the prime rate to 22.5%. This killed the inflation but the President lost his re-election easily which paved the way for Ronald Reagan to become the next President. You see the Fed is extremely powerful. But for the timely pumping of nearly 4 trillion US dollars by way of quantitative easing the US would have faced a very serious recession after the sub-prime crisis.

Student: What lesson do I take from here?

Professor: Loads of money is waiting to be made in trading. Given current negative interest rates in the Eurozone and Japan and the possible US interest rates moving up. A trader can make a fortune by buying the US dollar and selling the euro and the Yen. Gold which went up to $ 1290 an ounce is on its way down to much lower levels. As far Indian rupee is concerned, RBI intervenes and hence I cannot say much about it.

Student: Thanks Professor.

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