HOW FED BANK RATES WORK
Friends before I continue my previous article I would like to discuss Federal Reserve Bank and its proposed hike in the interest rates since it is creating ripples around the globe.
Have u ever scratched your head on how does the announcement of federal bank's interest rate hike can spook the financial markets in India.If yes then read on..........
Let us begin by Federal Reserve Bank.Federal bank is to U.S. what RBI is toIndia.It is the Central Bank .Central bank is the bank which in any country is entrusted with the duty of regulating the volume of currency and credit in that country. It also carries out the following functions
- Control Inflation
- Issue of notes
- Governments Banker , Agent and Advisor.
- Custodian of Metallic and Foreign Exchange Reserve
Controlling inflation is the most important work for any central bank .(Inflation in simple words is the situation where too much money chases too few goods).It may sound simple but it is not.Let us understand how a Central Bank(RBI or Federal Reserve Bank ) does it
The most powerful weapon that a central bank has is the ability to influence the interest rates. When interest rates are low, capital is easier to acquire. This can spur economic development because, human nature being what it is, the more money you have , the more you are likely to pay for something you want – whether it is a car or that i pod you want to flaunt. Left unchecked, the result is “too much money chasing too few goods” This results in inflation as companies realize that they can charge higher prices for their goods and services. Suddenly, it costs you more to fill up your car tank and watch the movie.
If interest rates are too high, however, the result can be a recession and, in extreme cases, deflation; the result of which can be economically devastating – imagine going to pay off your loan and realizing that, although the balance has not increased, it’s going to cost you more rupees in terms of purchasing power than it did before!
The interest rates get altered with the demand and supply of credit (amount of money that can be rendered to the borrowers).Say for example that you open a bank account, what you are actually doing is lending money to the bank and the bank will lend it to its other customers. The bank will use that money for its business and investment activities and pay you the interest depending upon the nature of account you have opened with them. The more banks can lend, the more credit there is is available to the economy. And as the supply of credit increases, the interest rates decreases. Credit available to the economy is decreased if lenders decide to delay the re-payment of their loans. For instance, when you decide to postpone paying this month's credit card bill until next month or even later, you are not only increasing the amount of interest you will have to pay, but also decreasing the amount of credit available in the market. This in turn will increase the interest rates in the economy. The central banks may change interest rates in any one of the following ways
By raising or lowering the discount rate.
By indirectly influencing the Statutory Liquidity Ratio ,Repo and inverse Repo rate
The discount rate is the interest rate banks are charged when they borrow funds overnight directly from one of the Central Banks. SLR is the portion of asstes that a bank has to keep in cash with the Central Bank.Repo Rate is the the rate at which dealer sells the government securities to the investor ,usually on overnight basis and buys them back the other morning.For the party selling the security its repo agreement and for the party buying the security it is the Reverse Repo agreement.
The interest rates have an inverse relationship with the bond markets i.e.when interest rates rise the bond prices decrease and vice versa. The rise in interest rates tend to affect the stock markets in the negative way.An increase in interest rates means that those people who want to lend enjoy an interest rate hike as he has oppurtunity to make more income but it makes the borrower less happy as he will have to pay more for the credit he takes.A decrease in interest rates means that those people who want to borrow enjoy an interest rate cut. But this also means that those who are lending money, have a decreased opportunity to make income from interest. A decrease in interest rates encourages investors to move away from the bond market to the equity market. At the same time, businesses enjoy the ability to borrow for expansion at a cheaper rate, thereby increasing their future earnings potential, which, in turn, leads to higher stock prices. Economists view lower interest rates as catalysts for expansion.
Now the big question is How the Federal interest rates hike can affect Indian Stock Market.In the past when fed rates were lower the fund managers and investors renounced investing money in low yielding bonds and invested in share market instead.Stocks were the flavour of the day.With low returns in the US equity markets the financial insttutions such as pension funds and mutual funds started investing in emerging markets such as India.Due to inflow of this FII(Foreign Institutional Investor) money the sensex surged from 3000 levels three years ago to 12000 levels in 2006.With the news of interest rates hikes by Federal Reserve Bank will prompt FII's to invest back in the US bond market .There is a flip side to this argument thou . The presumption that higher interest rates will enncourage investors to invest in US dollar denominated assets doesnnt hold water. Throughout the recent period when US interest rates were low, dollar-denominated assets were preferred by investors as a safe haven. Capital kept pouring into the US, triggering initially a stock market boom and, subsequently, because of their role in keeping interest rates down, a housing market boom. It has been held for some time now that, because the stock and housing boom inflated the value of assets owned by Americans and therefore their level of savings, US residents were encouraged to spend more of their current incomes on consumption resulting in a collapse of household savings rates to negative levels. The conspicuos repurcussion of this trend was buoyant domestic demand that helped sustain a creditable rate of GDP growth, despite the leakage of demand abroad reflected in large trade and current account deficits in the US balance of payments.
It could, therefore, be argued that if interest rates go up making borrowing more expensive, the domestic consumer spending and housing boom could be quickly reversed, resulting in a slow down of growth in the US and a loss of faith in the strength of the US economy. To the extent that this could affect investments in US assets, the fear that extremely high rates of growth in the US or excess speculation in the housing markets could force the Fed to raise interest rates, is seen as setting off shivers in stock markets as well.
The difficulty with this argument is that if it were true, then the downturn should have been restricted to US stock markets alone.
In fact, the exit of investors from the US should have been accompanied by a shift to other markets, which should have attracted more investments and witnessed a boom. However, recently equity markets worldwide, including the emerging economies, were rising when the US market was rising and declining even more sharply, with a short lag, when the US market slumped. This clearly makes the argument linking the downturn in the US market to the likely adverse effects of higher interest rates on domestic demand and growth an inadequate explanation of synchronised global trends. What is significant from the Indian stock market perspective is the nature of the FII holding and how it would behave in the coming days.
posted by naman tyagi @ 6:50 PM
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