Impact Of The US Federal Reserve’s Actions On The Indian Economy

Abstract

The US Federal Reserve has hiked its interest thrice since the start of 2023. The Fed has indicated that it would continue to increase its interest rate to curb inflation. However, these aggressive interest rate hikes harm the Indian economy. This paper analyzes the nature of US Federal Reserve policies and recent developments. The paper also looks at the impact of the Fed policies on other developing countries and attempts to link it with the Indian economy. Finally, the paper analyzes the effects of the Federal Reserve’s actions on the Indian economy from different dimensions and briefly looks at the way forward.

Introduction

The initial motive of any central bank is to achieve the critical goal of maintaining balance in the economy. The parameters that require attention while defining the monetary policy include stable prices, optimum level of employment (hypothetically, every country aims at achieving a cent percent employment), and a good proportion of investments in the economy. As it is generally known, the monetary policy of an economy is primarily determined by its central bank. Monetary policy is closely linked to maintaining price stability and keeping inflation under control. The monetary policy influences the exchange rates of an economy.   The value of an economy changes according to changes in the interest rate. Hence, a central bank framing a monetary policy does not limited to just the domestic economy itself. It has got its effect on the global setup as well. That is the reason there have been historical pieces of evidence of developing countries having the policy shocks of the changes in macro variables in developed countries. When the interest rates fluctuate, the aggregate demand changes and impacts the production of the firms and industries. More than that, it has an impact on the financial markets of the country, as people’s expectations change accordingly, and they react to what we call a market trend. However, we are not arguing that it had only a negative impact. Policy changes in developed countries may also boost the market in developing economies. The reasons any central bank makes specific changes in the monetary policy have been looked after in the first paragraph of the introduction. We must understand the critical difference between the monetary policy of developed and developing countries is the rate of growth they have to maintain. Developed countries have already achieved a specific growth rate, which essentially qualifies them as a developed economy. Hence, their job is to maintain a constant growth rate and keep inflation under control, not more than 2 %. In developing countries, there is always a trade-off between maintaining a high growth rate and controlling inflation simultaneously.  This is why we find the inflation rate regularly adjusted to 4-5% in developing countries. The point of this statement is that there is always a paradoxical situation in framing monetary policies in developed and developing countries. 

These features are commonly present not only in the policies formulated by the US Federal Reserve Bank and the Reserve Bank of India but also in the policies of most of the developed countries. The US Federal Bank considers the following motives while framing a particular monetary policy.  First and foremost is to set an economic policy for the economy as a whole. The second being to take a brief account of regional economies and financial conditions and predict changes.  The third and most important motive is to reach out to the public and convey the decision taken by the central bank. Considering the fact that the United States is a developed country, the Federal Reserve Bank has always tried to maintain a steady growth rate, keeping the inflation rate in control. The main aim of the Fed has been to control the price rise and its effects on the savings in the economy. This paper aims to analyze the impact of the Fed Reserve’s actions on the Indian economy. At first, it is essential to understand the journey of the US Federal Reserve Bank and the history of decision-making in determining macroeconomic policies.

What is the Federal Reserve Bank? How does it function?

Before the Fed Reserve was established, the United States had its central bank in 1791. It was much of a commercial bank performing the primary functions of accepting deposits and granting loans. The bank purchased securities and also issued bank notes. The fact that it was a nationwide bank and the governor was appointed by the government it could be considered the federal bank of the country.  The bank failed to gain the trust of the people. Its existence came to an end with a margin of votes falling against renewing its charter in 1811.  In 1816, a bill was passed to bring the charter of the second central bank of the US. The only difference was that it had more capital than the earlier central bank. The bank functioned for several years but did not have any federal regulations to operate with a central banking authority. National Banking Act passed in 1863 gave power to national charter banks to issue bank notes. The office of the controller of currency was set up. At the end of the 18th century, the second central bank, too, couldn’t function properly as the American economic structure grew immensely and became more complex due to the growth of industries. There were constant fluctuations due to business cycles and rigid currency. Finally, in 1893, depression hit the economy, and the banking system collapsed.

At the start of the 19th century, 1913, the Federal Reserve Act was created, which provided for the establishment of a Federal Reserve Bank. Currently, the US Fed is the most powerful banking institution in the United States. . The US Fed frames the country’s monetary policy. The headquarters of the US Federal Reserve Bank are located in Washington, DC. The Fed operates in 12 US states. The power is shared by a seven-member board of governors, which is led by the Fed chairperson appointed by the president.  The Fed has 12 regional bank presidents, of which five are included in the larger portion of the Fed Open Market Committee (FOMC).  The Open Market Committee is responsible for adjusting the interest rates and controlling or expanding the money supply. The main reason for maintaining the interest rates is the ‘dual mandate’ set by the Fed. It aims at achieving stable prices and full employment. The Fed chairperson is the spokesperson or mediator who deals with Congress and the FOMC. 

The Fed generally uses the following tools to control inflation.  These include open market operations, discount rate, reserve requirements, and the federal funds rate. 

Open Market Operations

The open market operations involve purchasing and selling government securities in the market by the country’s central bank. Before the 2008 global financial crisis hit the US economy, these operations were used to balance out the Federal funds rate to adjust the money supply.

Discount Rate

The Discount rate is the interest rate charged on the loans received by the commercial bank by the Regional Federal Reserve Bank.  Usually, there are three types of loans offered. The primary, the secondary, and the seasonal credit. These loans are fully secured. The loans are lent at similar discount rates at all the regional reserved banks. 

Reserve Requirements

The reserve requirements are the amount of reserved cash banks need to keep with them. As authorized by the Federal Reserve Act, the board of members establishes specific ranges of reserve requirements to set up the monetary policy. It is laid on certain types of deposits and liabilities. The reserve amount is determined by applying reserve requirement ratios provided by the board rules. 

Federal Funds Rate

The Federal funds rate is the interest rate at which the commercial banks lend and borrow their excess reserves from each other. The FOMC determines it by conducting meetings periodically. It influences short-term loans deposits of the customers.

We shall now look at a historical analysis of monetary policies designed by the Fed in the context of some important time frames ranging from the 1990s to 2018.

Historical analysis of Federal Reserve monetary policies

The actual recessionary period for the US economy was 1999 to 2009.  In 1999, the Asian economies were hit by a wave of business cycles. It was the decade where the US exports were mainly towards the eastern countries. The devaluation of currencies reduced demand for the products of the United States. As a result, there was a huge trade deficit in the economy.

Moreover, the devaluation meant that the Asian countries started producing their own goods and substituting them for exported commodities. Due to the fall in the value of other currencies, there was a rise in the dollar price compared to other currencies. These trade deficits naturally resulted in overproduction, putting the economy into recession. The unemployment rate was under control, but the number of new jobs created was reduced, and a more significant portion of them were in industries offering jobs with low wage rates. The first impact of global imbalance was on the financial sector of the U.S. economy. The profit levels of corporate stocks came down as risk-averse investors, both domestic and international, withdrew their investments.

Consequently, in 2000-2001, the Federal Reserve reduced the interest rate to tackle inflation and boost up the domestic demand.  In 2004, the interest rates were relatively lower; the idea was to make people spend more. The Fed consistently hiked the interest rates from 2004 to 2006 17 times. The sole motive of this move was to increase the consumption and domestic demand for the commodities so that unemployment could be reduced. On the contrary, it cut the interest rates to almost zero to rescue the economy from the 2008 economic crisis. 

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