The US Federal Reserve has hiked interest rates by another 25 basis points.
What is it?
The Fed Funds Rate is the interest rate at which the top US banks borrow overnight money from common reserves.
All American banks are required to park a portion of their deposits with the Federal Reserve in cash, as a statutory requirement.
The US Fed, unlike our RBI, isn’t a single entity. It is a web of institutions made up of a Board of Governors based in Washington, 12 Federal Reserve Banks across key US cities and private banks.
Together, the Board and the 12 Federal Reserve banks regulate US lending institutions, act as lenders of last resort and watch out for the interests of depositors.
The Federal Open Market Committee (FOMC), which decides monetary policy in the US, does not actually ‘fix’ the Fed Funds Rate.
What it does, after announcing its target, is to direct open market operations to pull or push this rate into its target range.
The Federal Reserve Bank of New York, the kingpin in the Fed system conducts open market operations to ensure that the Fed Funds Rate behaves itself.
To push the rate downwards, it mops up government bonds from the common reserve and infuses cash.
The higher liquidity then allows banks to trim their lending rates. To lift this rate, it sells government bonds and vacuums up liquidity from the system.
Why is it important?
The Fed Funds Rate is the key indicator of the direction in which US interest rates are heading at any given point in time.
If the Fed is hiking rates, lending rates for companies and retail borrower increases, and vice versa.
Unlike India’s repo rate, which may not matter much to anyone across the borders, US interest rates matter a lot to global capital flows.
A good chunk of the world’s wealthiest investors and institutions have their home in the US.
They are therefore constantly comparing interest rates outside the US, to those in their home country, to make their allocation decisions.
The dollar is the default reserve and trading currency of the world.
This too makes US interest rates an important factor deciding the direction of global trade and investment flows.
Why should we care?
The RBI does keep an eye out for Fed actions when it decides on rate hikes.
For instance, with the Fed Funds Rate headed upwards now, RBI will have to think twice about cutting its policy rate, as this can lead to foreign investor pullouts from the domestic bond market.
The Indian bond market did see immense pullouts of over $6 billion in the six months leading up to the FOMC meeting.
The US interest rates matter to stock investors too.
For long, the high valuation for Indian stocks was justified on the count that zero or near-zero returns on safe investments in the US and elsewhere made foreign investors more willing to pay a high price for Indian stocks that’s till offered some growth.
