Are Interest Rates In India Linked To US Interest Rates?

The rate of interest prevailing in a country is one of the most important factors in deciding how investors – individuals as well as companies – allocate their funds to maximise their returns. If interest rates are higher than usual, then investing in fixed-income products could be beneficial; if they are lower than they would be in normal circumstances, other avenues could provide more bang for the buck.

But what if you could predict how interest rates are going to move, or at least make educated guesses? Investors and financial market experts do this all the time by trying to interpret what economic developments could mean for the interest rates trajectory. Often, they will also look abroad – specifically, the Federal Reserve, the central bank of the world’s largest economy, the US – and see what actions are being undertaken there in the hunt for clues. 
 

Who decides interest rates in India?

Interest rates in India are decided by the Reserve Bank of India. The Indian central bank has a six-member Monetary Policy Committee that meets every two months to decide on what should be the level of the repo rate. Currently, it stands at 6.5 per cent, having been left unchanged for more than a year. 
 

Of the six members on the Monetary Policy Committee, three are from the Reserve Bank of India – the governor of the central bank, the deputy governor in charge of monetary policy, and an officer decided by the board of directors of the central bank. 
 

The remaining three members of the committee, called ‘external members’, are decided by the Indian government in consultation with the Reserve Bank. These external members are normally academics with expertise in finance and economics. 
 

What is the biggest factor behind interest rate decisions?

The Monetary Policy Committee of the Reserve Bank of India is mandated that it must focus on inflation and growth while deciding interest rates. For inflation, the legal target is 4 per cent in a band of 2-6 per cent. However, the law does not specify any particular target for growth. As such, the Indian central bank has some flexibility. 
Clearly, inflation is the biggest determinant of interest rates in India. If it is rising above the 4 per cent target, the likelihood of the Reserve Bank increasing interest rates is higher. This, along with the Reserve Bank of India’s inflation forecasts, provides a good indicator to investors on the future course of interest rates. 
 

Does the RBI monitor what other central banks do?

While the RBI must decide what level the repo rate should be set at, it has to constantly be vigilant on the potential impact of others’ actions on India. 
 

Consider the US Federal Reserve, for instance, which is considered the world’s most powerful central bank. Why? Because its policy decisions can force other central banks into making changes because of how money moves around the world in response to changes in interest rates. 
If the US Federal Reserve suddenly decides to increase interest rates, it will attract some money from other countries. This may not necessarily be foreign money but also US money that had been invested abroad in the hope that the foreign investment will generate greater profits. But as US interest rates keep increasing, more and more of this money is likely to return home to American assets. 
 

At the moment, the US Federal Reserve’s main interest rate is at 5.25-5.5 per cent, with a 10-year US government bond providing a yield of 4.43 per cent. However, in early 2022, the main interest rate was near zero and the 10-year bond yield was at 1.6 per cent. As such, the returns on US government bonds and other American fixed-income instruments have been increasing steadily over the last couple of years. 
 

What is interest rate differential?

Just like the US, India has had to increase its interest rates in the last two years to bring down high inflation. However, the increase in Indian interest rates has been much smaller. 
 

In early 2022, the Indian repo rate was at 4 per cent and the US federal funds rate target range was 0-0.25 percent, resulting in a gap of about 375 basis points between the two. One basis point is one-hundredth of a percentage point. 
 

Fast forward two years, and the gap – called the interest rate differential – has shrunk remarkably. In May 2024, the Indian repo rate stands at 6.5 per cent while the US federal funds rate target range is at 5.25-5.5 per cent. This means the gap between the two is just 100 basis points or so. 
If the interest rate differential with the US narrows sharply, it can cause huge problems for the other country, which in this case is India. As mentioned above, rising US interests can make US investments increasingly more attractive and lead to exit of money from other countries such as India. 
 

When capital exits a country for another country, it affects the exchange rate of the two countries involved. For example, if money goes from India to US, the rupee becomes cheaper in terms of the US dollar. This weakening of the Indian currency can have several knock-on effects, including a rise in domestic inflation. 
 

Does India have to hike rates if the US does?

With the interest rate differential between India and the US having narrowed appreciably in the last two years, the question arises whether the Reserve Bank of India needs to take any measures to ensure there are no adverse consequences? Does the RBI have to hike interest rates in tandem with the Federal Reserve, effectively linking the two? 
 

The answer is no. Fortunately, foreign investors have put their money into India because the opportunity of higher returns than elsewhere is backed by a robust economy. India has been the fastest growing large economy for a while now and shows no signs of letting up. Continued growth momentum, continuity in government policies, and controlled inflation are some of the key attractions for foreign investors that can obviate matching interest rate changes.