US Fed Interest Rates Hike

What is the issue?

• U.S. Federal Reserve again raised its benchmark short-term interest rate by 25 basis points to 1.75%, the highest in a decade.
• This monetary tightening is driven by the confidence in the markets, but there are inherent risks which call for caution.

What is the trend in US monetary policy?

• The 2008 economic crisis pushed central banks worldwide to cut interest rates to historic lows in order to overcome recession.
• These loans were facilitated by public borrowings and monetary policy easing and hence had to be serviced at some point in the future.  
• So, US Federal Reserve (which control’s monetary policy), has been tapering liquidity lately, as the US economy seems to have recovered fully. 
• While the current increase is only the 6^th since the financial crisis of 2008, the trend ahead seems unambiguous for further increases.
• Notably, US economy is projected to register strong growth ahead.
• The resultant inflationary pressures might push Fed rates further for the next 2 years.

How has its impact been?

• To reverse the post-2008 liquidity easing, the Fed and other central banks have initiated normalisation of monetary policy.
• The impact of these on the wider credit markets is slowly beginning to show in the markets.
• The “interbank lending market” has been directly influenced.
• Significantly, the benchmark “London Interbank Offered Rate” (LIBOR), at which international banks lend to each other has also been increasing.
• LIBOR has risen for more than 30 consecutive sessions and is currently at its highest since the financial crisis.
• Also, the corporate debt market has clearly been impacted.
• The rising rates could adversely affect the capacity of private firms to service their debt.

What are the challenges?

• Debt Default - The risk of default by private borrowers has been flagged by various organisations recently, including the IMF.
• Notably, private corporations attracted by ultra-low interest rates had heavily loaded up on debt over the last decade.
• Also, some companies borrowed heavily from across the borders, thus making them prone to exchange rate risks as well.
• Ironically, the 2004-2006 period saw the Fed raising rates to tackle inflation.
• But it ultimately led to a mass default of mortgage debt and precipitated the 2008 crisis.
• Trade Protectionism - US President Trump’s steep tariff raise against imports from China had recently forced down stock values across markets.
• These trade wars will clearly have a negative impact on global growth.
• Corporate earnings and these policy uncertainties seem to be a long haul.
• Capital Flux - Rising interest rates would also see capital outflow from emerging markets due to liquidity crunches.
• This is particularly a concern for India.

Source: The Hindu