Federal Reserve of US increased interest rate by 0.25% for the first time since 2006

The Federal Reserve System, the central banking system of the USA, on 16 December 2015 increased interest rate by 0.25 percent. A decision in this regard was approved by the Board of Governors of the Federal Reserve System chaired by Janet L Yellen.

With this, the interest rates in the US are now in the range of 0.25 – 0.50 percent as compared to zero to 0.25 percent range earlier. This is the first rate increase since 2006.

In December 2008, three months after the collapse of investment bank Lehman Brothers Holdings Inc, the interested was kept in the near zero range to stimulate the economy and consequently, tide over the financial crisis.

Why the Fed increased the interest rate?

The decision to hike the interest rate was taken against the backdrop of economic recovery in the country.

A range of recent labor market indicators, including ongoing job gains and declining unemployment indicate further improvement and confirms that underutilization of labor resources has diminished appreciably since early 2015.

More importantly, the inflation is expected to rise to 2 percent over the medium term which is and indication of growing demand in the market.

Hence, to consolidate the ongoing recovery process of the economy, the Fed decided to increase the interest rate.

Impact on emerging economies

In the last one decade, emerging economies in general and India in particular benefitted in the form of higher investments especially into the capital market. The comparatively high interest rates attracted capital inflows which helped in increase of production and also domestic consumption.

The present hike in interest rate might affect the capital flows into developing economies like China, India, Malaysia, Indonesia, South Korea, etc. As per an estimate of the Institute of International Finance (IIF), the net capital flows for global emerging markets will be negative in 2015, the first time that has happened since 1988.

Further, it may increase the borrowing cost, especially of the dollar-denominated loans, for companies in emerging markets. The rate increase, however, would have greater impact on export-oriented economies especially China and South-East Asian economies.

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