A Brief Overview of the Federal Reserve

The Federal Reserve, often referred to as the Fed, is the central banking system of the United States. It was established in 1913 under the Federal Reserve Act, with the primary aim of addressing financial crises and fostering economic stability.

• The Federal Reserve comprises a Board of Governors based in Washington, D.C., along with 12 regional Federal Reserve Banks situated in major cities across the country.
• The Fed's key responsibilities encompass conducting monetary policy to promote price stability and full employment, supervising and regulating banks and other financial institutions, and providing financial services to the U.S. government and other banks.
• The Fed employs a variety of tools to fulfill its monetary policy objectives, such as setting interest rates, carrying out open market operations, and adjusting reserve requirements for banks.
• The Federal Reserve also plays a pivotal role in the U.S. financial system by acting as a lender of last resort during times of financial crisis. This means the Fed can provide loans and liquidity to financial institutions facing short-term funding issues, thereby helping to avert wider financial instability.

Implications of the US Fed Interest Rate Hike

Effect on Asset Prices:

• A rise in interest rates typically leads to asset prices being discounted at a higher rate.
• As interest rates increase, investors expect higher returns on their assets, which results in a drop in prices.
• Even U.S. Treasury securities, widely regarded as the safest assets worldwide, are not immune to interest rate hikes.
• Investors holding long-term U.S. Treasury securities like 10-year and 30-year bonds face substantial unrealized losses due to the rise in interest rates.

Effect on Banks:

• The decline in asset prices has led to the downfall of some banks, including Silicon Valley Bank and Signature Bank.
• Silicon Valley Bank, which had 55% of its assets in securities, faced an unrealized loss of over $18 billion, pushing it towards severe financial distress and possible collapse.
• Although U.S. Treasury securities are safe assets to hold, no asset is entirely risk-free. Therefore, it is crucial to consider unlikely scenarios that could potentially wipe out one's holdings.

Effect on India:

• To minimize spillover effects, the Reserve Bank of India ( RBI ) may need to hike interest rates in sync with the Federal Reserve.
• A significant gap in interest rates could lead to currency depreciation, resulting in increased import costs and inflation. Therefore, India needs to tackle its inflation issue by raising interest rates, regardless of the Federal Reserve's actions.
• Banks may need to increase their lending rates to maintain their net interest margin in line with the RBI.
• In response to the RBI’s policy, the State Bank of India increased its housing loan rate to 8.5% as of March 2023, a significant rise from the low of 6.75% in 2021.

Effect on Borrowers:

• The increase in interest rates means that individuals with EMIs may find it difficult to maintain their standard of living due to potential wage cuts and job losses.
• Loans and EMIs alone do not ensure a better quality of life for salaried individuals.
• To navigate financial difficulties, it is crucial to live within one's means, build a safety net by investing in the stock market, and manage EMIs without accruing additional debt.

Positive Real Rates and Inflation:

• Some economists argue that positive real rates are necessary to effectively combat inflation.
• Despite a steady decline in inflation rates from 9% to 6% over the past year, continued inflation underscores the need for the Federal Reserve to take further steps to increase rates.

Conclusion:

• The Federal Reserve's aggressive stance on interest rates has wide-ranging effects on the economy, impacting asset prices, banks, and borrowers. While rate hikes are necessary to tackle inflation, it is vital to consider the unintended consequences and prepare accordingly.