Significance of US Federal Reserves rate cut and its impact on India

Headline : Significance of US Federal Reserves rate cut and its impact on India

Details :

In News:

  • The US Federal Reserve has recently announced a quarter-percentage-point cut in interest rates, the first rate cut by the US central bank in 11 years.

About US Federal Reserves rate:

  • The fed funds rate is critical in determining the U.S. economic outlook.
  • It controls short-term interest rates including banks’ prime rate, most adjustable-rate and interest-only loans, and credit card rates.
  • The 2008 recession caused the Federal bank to lower its benchmark rate to 0.25% which is effectively zero.

News Summary:

  • The central bank of U.S. reduced its benchmark rate which affects many loans for households and businesses by a quarter-point to a range of 2% to 2.25%.
  • The Fed has also signaled a readiness to lower borrowing costs further if needed.
  • It is the first rate cut since December 2008 during the depths of the Great Recession, when the Fed slashed its rate to a record low near zero and kept it there until 2015.
  • This move comes despite a strong US economy and indicators such as job market data showing renewed buoyancy.

Reason cited for rate cut:

  • To counter threats ranging from uncertainties caused by trade wars, chronically low inflation and a dim global outlook.

Repercussions on Indian Economy:

Negative Impacts

  • Increased Trade deficit:
    • Lower interest rates and a weaker dollar also means stronger gold. From the Indian point of view greater investment demand for gold can surface putting pressure on a trade deficit.
  • Decrease in demand for Indian products:
    • A rate cut cycle means a weaker dollar, as the dollar weakens due to lower growth tendencies, the rupee has tended to strengthen.
    • This will slower demand from Indian exporters due to lower global growth and thus will further increase current account deficit (CAD).

Positive Impact

  • More investment in emerging economies like India:
    • Emerging economies such as India tend to have higher inflation and thereby higher interest rates than those in developed countries such as the US and Europe.
    • As a result, Foreign Investment Inflows would want to borrow money in the US at low-interest rates in dollar terms and then invest that money in bonds of emerging countries such as India in Re terms to earn a higher rate of interest.
    • When the US Fed cuts its interest rates, the difference between interest rates of the two countries increases, thus making India more attractive for the currency carry trade.
Section : Economics