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Fed rates and Indian domestic economy

The relation between the Fed’s interest rates and the markets here

The US Federal Reserve has decided to leave the interest rates unchanged. However, it has expressed concerns on the escalating crisis. The unanimous decision left the benchmark overnight rates at two percent. The Fed has said, 'strains in the financial markets have increased significantly and labour markets have weakened further'. The central bank said it also remained concerned about the inflation pressures. The Fed said the downside risks to growth and upside risks to inflation are of significant concern to the committee. The move is expected to enable banks in the US to borrow money for the short term from the Fed as well as lend to each other at the same rate as before.

In the past few months, the Federal Reserve had been cutting US short-term interest rates amidst concerns that the economic growth will slow down in the coming months. The effort was to stimulate economic activity and keep the country from dipping into a recession. According to the Federal Open Market Committee (FOMC) the upside risks to inflation roughly balanced the downside risks to growth. Earlier, the FOMC had indicated that the strains in the financial markets had somewhat eased. Housing is likely to slow the pace of economic slowdown, it added. Though, some inflation risks is arising.

With the last year bankruptcy of the financial major Lehman Brothers and troubles of AIG, the Fed had no other option but to keep the interest rates steady. A good point was that the oil prices have somewhat eased. According to the Fed, the pace of economic expansion will slow down in the near term, partly reflecting the intensification of the housing correction.

Last year, the Fed had slashed borrowing costs periodically. The concerns over housing and credit seem to be dominant. The Fed had reduced rates in an effort to keep the economy growing at a 'moderate pace'. The move was aimed to avoid a recession.

The central bank's present move will offer some relief to the ailing credit markets which have tightened as major commercial banks have sustained hefty losses tied to mortgage backed securities. This action will help stabilise the financial markets.

There are still sectors of the credit markets that are not functioning very well. Without enough capital, firms hesitate to invest.

The Fed has cited concerns of rising energy and commodity prices which could renew inflationary pressures. Also, housing and credit worries outweigh inflation risks. Sales of existing homes and apartments have dropped.

Inflows from abroad may reduce after the Federal Reserve maintained interest rates. There would certainly be some repercussions on the domestic markets. It may be a signal to the Reserve Bank of India (RBI) that interest rates need to be maintained at the present levels.

In the past, the rate cuts by the Fed have translated into a major boost for the domestic stock markets, and increased inflows of foreign funds. With an increase in foreign funds, the dollar depreciated against the rupee. So, exporters felt the pinch. Moreover, with foreign funds pouring in, liquidity increased and the risks of inflationary pressures also increased. A fresh flood of capital complicated the monetary and inflation management for the Reserve Bank of India. There were pressures on asset markets (stocks, bonds, currencies) on the back of risk-aversion induced capital outflows. The US holds significant implications for emerging markets.

The Fed interest rate stability helps the worth of US dollar-denominated investments. The dollar is likely to stop depreciating further against the rupee. The rupee has appreciated nearly 12 percent against the dollar in the last one year. The rising rupee value prompted most engineering and textile sector exporters to go for forward bookings of export shipments. This can help the competitiveness of exporters, especially textile and garment players.

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