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Fed chairman Jerome Powell

The Federal Reserve has increased interest rates by 25 basis points. Now Fed funds rates are bettween 5%-5.25%. Market got indication from Fed chairman Jerome Powel’s speech that rate hikes will be paused from here on. Market had already factored 25 bps hike but indication that there won’t be further increase lifted market sentiment.

Impact of interest rates in economy and market

Let us go back to basics and see how interest rates actually impact the economy.
Interest rate is hiked when aggregate demand is high but the economy doesn’t have enough resources at the moment to fulfill demand. So higher demand will only lead to higher price levels.

The interest rate is the price of borrowing money and also reward for parting with your money. So basically if interest rates are high then people, investors will borrow less and instead they will deposit money. Now they will deposit money by withdrawing it from their consumption and other assets. These assets include real estate, shares, commodities.

This impacts the stock market negatively in two ways.

On one hand, money directly flows out of equity market. 2nd there is negative sentiment regarding economy and growth of companies which again leads to fall in share prices.

Fed Decisions

Coming to Fed. It has increased interest rates by 25 basis points. But Powel’s speech have given some indications that rate hikes will pause. There are indications that economy, demand and labour market are becoming soft. Besides this there are banking crises.

On the other hand, labour market is still strong. Which indicates economy is very close to its potential (meaning how much it can actually produce at full capacity). If demand continues to remain strong right now it will lead to price hikes. Core inflation in the US has remained elevated. In it, volatile components like food and energy sector are excluded. Central banks use core inflation as inflation expectations proxy and make all decisions according to it. Hence there are mixed signals from economy.

Still, central bank wants to keep inflation expectations in check. Right now there are 1.6 vacancies per unemployed (Indicating high labor bargaining power).  If they will go out of hands, then workers will start asking for exhorbitant wages. Which in turn will compel firms to raise prices, workers may then again ask for more wages and this may spiral out of hand.

Way ahead

Right now data from US economy may indicate some softness but economy is close to its potential. After current increase it seems that enough medicine (high interest rates) is given. Now its effect comes with lag, meaning people will gradually realise price of money has increased and inflation is cooling down. So their inflation expectations will fall, along with that banking issues may make banks risk averse. So they will lend less. Hence economy will cool down from current heated level without causing long term burns to consumers, workers and companies.

However, we should keep in mind that all these linkages and effects are quite complex so you never know how things will turn out. Hence Fed may have given some hint that it may not increase rates further but it will closely track the situation and if economy remais heated don’t be surprised if there is one more hike.

If that happens then we might witness fall in not just US markets but also in Indian markets and rupee as investors will fly towards US debt markets. It might even make RBI’s job more difficult as to weather focus on domestic monetary policy, rupee level or capital flows in the country. Only two out of three can be controlled. On bright side, this scenario doesn’t look very likely and there are higher chances that Fed may not increase rates for some time from here on.