Interest rates. Fed rate hikes and unintended consequences

The Federal Reserve began raising rates in March last year (2022) and has consistently pushed the federal funds rate since.

In May 2022, it announced the most significant rate increase since May 2000 to tackle rising inflation. Over the past year, the Fed has pushed the discount rate from 0.25% to 5.0%. This has been an unprecedented increase in interest rates to fight inflation and address the concerns regarding a tight labour market.

Positive real rates

Over the past year, the inflation rate has steadily declined from 9% to 6%, but according to multiple economists, there must be positive real rates for inflation to be genuinely tackled. Persistent inflation signals the Federal Reserve has its work cut out over the next few months regarding rate increases. However, a robust hawkish stance comes with inevitable unintended consequences which must be accounted for.

Read also: Editorial. US Fed’s mixed signals

The immediate result of an increase in interest rates comes from asset prices being discounted at a higher rate. A higher interest rate signals markets to demand higher rates of return from their assets which causes prices to drop to accommodate the demand for higher rates. U.S. treasury securities, reputed to be the safest asset in the world, are not immune to the rapid rise in interest rates. The U.S. 10-year and 30-year treasury securities holders have are staring at severe unrealised losses in asset holdings due to the increase in interest rates. A direct consequence of this decline in asset price is the collapse of the Silicon Valley Bank and Signature Bank.

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Silicon Valley Bank (SVB) had 55% of all its assets in securities leading to them facing a total unrealized loss of more than $18 billion. Typically, unrealised losses do not necessarily signify a bank’s impending collapse.

However, SVB also possessed a measly 2.5% of assets in cash compared with other banks in the U.S. A bank-depositor run forces a bank to either liquidate assets or raise funds to pay off depositors. SVB was forced to realise its losses on the treasury bills it held, destroying capital and putting them in severe trouble and at risk of collapse.

A famous investor, Howard Marks, popularised the metaphor of a six-foot man drowning while crossing a stream that was five feet deep on an average. The metaphor lends itself to this case where the U.S. treasury securities are safe assets if one has the liberty to hold them.

No risk-free asset

Mr. Marks also states that no asset is risk-free, and one should always factor in scenarios which seem unlikely or impossible but can wipe you out whole if they occur.

On the other hand, one cannot ignore the spillover effects of the Federal Reserve’s hawkish stance on India. The Reserve Bank of India (RBI) is also forced to keep up with the Fed and raise rates. The reason for this is twofold:

1) A significant enough interest rate disparity would lead to a depreciating currency making imports expensive and leading to runaway inflation.

2) India faces an inflationary problem of its own and requires rate increases regardless of the actions of the Federal Reserve. Banks’ lending rates must rise to keep up with the RBI to maintain their net interest margin.

The State Bank of India has consistently raised its teaser housing loan rate from a low of 6.75% during 2021 to 8.5% as of March 2023. Although this jump may not seem drastic, it is possible to illustrate the gravity of the hike through a numeric example. If one borrows ₹1 crore at 6.75% with a tenure of 20 years, the EMI works out to be ₹76,036 a month. However, with an interest rate of 8.5%, the tenure taken to repay the loan at the same EMI level is about 31 years.

Now, if we were to allow rates to rise to 9% (a reasonable expectation considering rising interest rates), the tenure taken to pay back the loan goes up to about 45 years.

This is the potent effect of compounding visualised by the famous investor Charlie Munger. Moreover, interest rate increase signals wage decreases and impending job losses.

Therefore, it is difficult for those with EMIs to continue to maintain their standard of living in current times. Such times remind us that loans and EMIs are not a panacea which guarantees a greater quality of life for those on salaries. To weather the storm, one must be careful in living within means and working on a nest egg by indexing in the stock market. Additionally, paying off any EMIs which one has and not purchasing any goods or assets through debt is crucial.

(Anand Srinivasan is a consultant and Sashwath Swaminathan is a research assistant at Aionion Investment Services)