When the Federal Reserve (the Reserve Bank of India’s counterpart in the US) talks about change in interest rates, investment gurus listen. A slight hint or change in the interest rate is enough to cause upward or downward movements in stock markets worldwide. Since the US stock indices lead the recent downfall of stock indices worldwide, equity investors are keen to know the consequences arising from the monetary policy initiatives.
Interest is an amount of compensation a lender receives for taking a risk with loan he gives to borrowers, as there’s a risk that the borrower may not be able to payback.
The economic goals of the regulator are to facilitate economic growth, control rising prices and moderate interest rates so that growth is not affected.
The regulator uses monetary policy tools, including interest rates, to achieve these goals.
If the RBI lowers the bank or reverse repo (the rate at which banks borrow from the central bank), then banks can borrow money for less. In turn, they can lower the lending rates, making their loans more competitive. If an individual is thinking of buying a house or a car, and the interest rates become attractive or affordable, he/she may decide to take a loan and fulfil this aspiration.
The economy grows when consumers spend more. That’s why the stock market tends to go up when the RBI lowers interest rates, or even hints at lowering interest rates. It’s a sign for people buying more goods and services, boosting demand for products and services of companies (mostly listed).
Besides, lower rates make other investments less attractive. Bonds and other rate sensitive deposits may not pay as much as risky investments like the stock markets do. Infusion of more money into the equity markets will in turn raise the stock prices, boosting asset values of companies.
A cut in rates also dec reases the value of rupee in the foreign exchange market.
Although weak currency is not favourable for an economy in the long run, it may be good in the short-term for exporters as the same unit of their goods fetches more returns in the domestic currency. But makes imported goods and services more expensive.
In contrast, when consumers spend more, the economy grows, which in turn creates inflation due to demand outpacing supply—then it can lead to rise in interest rates. Regulator may increase interest rates if money supply increases at a faster rate than anticipated.
Higher money supply is an indicator for higher purchasing power of consumers. While growth is necessary, unbridled growth could lead to imbalances in the economy, prompting RBI to rein in inflation and money supply.
Whenever stock markets see a rise in inflation, they sense some sort of corrective measures. Every commercial bank must keep a part of their deposits with the RBI, which is called Cash Reserve Ratio (CRR). If the RBI reduces CRR, lendable resources of the banks get a leg up and vice versa.
Hence, the stock prices, especially stocks from rate sensitive sectors like banking, real estate and automobiles, always respond feverishly to changes in interest rate and inflation data.