Fed Rate Hike in simple words [ In Context of India ]

Fed Hike or Fed Rate Hike are just the anonyms.

To understand this, first we have to break it in parts :-
*Fed  ~ Federal (Fed) Reserve Bank is the central bank of America.
*Rate ~ It signifies the interest rate charge by the banks.
*Hike ~ It means increase (of interest rate).

Only meaning is not enough unless you understand on what basis Fed raises rates, why they do, how rates are decided & so on.

So, lets train in a summarized manner :)

Pic Credit - CNN Money

⇛What is Federal Rate or Federal Fund Rate ?

• It is the interest rate charged by depository institutions (say Banks) from other banks.
• But only when they borrow/lend money to each other overnight, or without any collateral (security).

⇛What is Federal Funds ?

• Federal Funds are those funds which are deposited by the banks with the Federal Reserve to meet 'Bank Reserve Requirements' (In India, it is known as 'Cash Reserve Ratio').
• Generally, it is a percentage of deposits which changes time-to-time by Federal Reserve to stabilize economic growth. 

⇛Mechanism 

• Suppose, Bank Reserve Requirement (BRR) is that each bank has to deposit $1 million with Fed on a daily basis. Now, every bank may not have this amount.
• So, banks starts borrowing/lending to/from other banks who have the surpluses/deficits to meet their requirements. 

Now, you have understood the bottom of Fed system, its time to move towards bottleneck.

⇛Why Fed raises rates ?

As Fed rate is the most influential rate in the world, since it affects monetary & financial conditions, which simultaneously affect the employment, growth & inflation in the economy. So, here are the reasons of hiking it :-

• U.S. want to achieve inflation target of 2%.
• To remain less money available in the economy.
• Ultimately, borrowing become expensive between banks & financial institutions.
• There is a relationship between interest rates & unemployment rate, once the rate of unemployment nears to 'Full employment' the danger of uncontrollable inflation (in future) becomes a worry. In this case, when people starts getting jobs, there will be growth in consumer spending, investments, etc. To limit this, Fed raises rates.      

⇛What is the Impact on India ?

• As interest rates in U.S. rises, other countries with stable interest rates become less attractive in giving return (gain by investing) to investors.
• Foreign Institutional Investors pull out the money from India & invest into U.S.
• Crude oil price & Inflation has the direct relation in India (due to rise in interest, crude oil price also rises in U.S. therefore Indian importer will pay more. Crude oil which works as a raw material for many products, will make finished products more expensive & ultimately increase inflation in India.
• Now on the export side, there will be definitely boost in exports because Indian currency will be depreciated & exporters will receive more stronger foreign currency. Hence, there will be trade surplus.

⇛On what basis they raises rates

• Fed keeps an eye on inflation indicators such as Consumer price index (CPI) & Producer Price Index (PPI).
• When these indicators starts to rise more then 2-3% a year, the Fed will raise the federal funds rate to keep rising prices under control.

⇛Who decides Fed Fund Rate ?

• FOMC (Federal Open Market Committee) sets desired target for the Federal funds rate through Open Market Operations (OMO).
• OMO refers to a tool in which Fed Reserve buys or sell securities from/to commercial banks.
• This tool helps in raising/lowering the interest rates.
• So, when Fed wants to raise interest rates, it sells the securities to the banks (known as 'Contractionary Monetary policy') & vice versa (known as 'Expansionary Monetary Policy')