Tuesday, June 23, 2015

Why does a rate cut matter?

This article was first published in www.rediff.com on June 23rd, 2015; Co-author: Anisha Sircar, Flame University, Pune 


The Wholesale Price Index for May 2015 stood at minus 2.36 per cent, continuing its downward trend since the last seven months. The Consumer Price Index stood at 5.01 per cent, well within the range of 2-6 per cent targeted by the Reserve Bank of India. With the release of these figures on June 15, 2015, the demand for a further rate cut have resurfaced.

The industry associations like Confederation of Indian Industries and FICCI have already issued statements to the effect that Reserve Bank of India should continue the “rate easing cycle” to “support demand”.

Repo Rate
Earlier this month, on June 2, the Reserve Bank had cut the Repo rate by 0.25 per cent, third time this year. Repo rate (short for ‘Repurchase Agreement Rate’) is the rate at which the central bank lends money to commercial banks.

When banks experience a shortage of funds, they may borrow money from the RBI. When the RBI increases the repo rate, it becomes more expensive for banks to borrow money, creating a ripple effect that affects businesses and individuals.

Higher the interest rates to acquire loans, lower the profits yielded, which may result in spending cuts and a slowdown in the overall growth of companies.

Similarly, an increase in repo rate results in banks increasing their interest rates charged for consumer loans as well, thus reducing the purchasing power of individuals. The diminished ability for consumers to spend discretionary money results in reduced demand for goods and services and affects businesses as well.

Stock Markets
Stock prices are a function of business operations and expectations people have viz. companies at different points in time. If a company is seen cutting back on spending or making less profit, the expectations of people from that company may go down, resulting in a lower demand for the shares of that company. With decreased demand for the shares of a particular company, the share prices start to fall.

When a macroeconomic factor, such changes to the repo rate, affects the entire market, the indices (like Nifty or Sensex) would go up or down, representing the impact on the market as a whole.

Therefore, when the repo rate is cut, the general effect is an increase in the amount of money in circulation, which makes the stock market a more attractive area of investment.
(However, it is important to note that repo rates are not the only determinant of stock prices and market trends. It must also be noted that the stock markets represent only the organised (listed) sector of the economy. And the indices only represent some of the largest companies listed on the stock exchanges).

Market Reaction
Usually, as in January 15 this year, a repo rate cut should create a positive effect in the stock market.

On June 2, the RBI governor cut the repo rate by 25 basis points to 7.25 per cent. Raghuram Rajan announced, "Banks have started passing through some of the past rate cuts into their lending rates, headline inflation has evolved along the projected path, the impact of unseasonal rains has been moderate so far, administered price increases remain muted, and the timing of normalisation of US monetary policy seems to have been pushed back. With low domestic capacity utilisation, still mixed indicators of recovery, and subdued investment and credit growth, there is a case for a cut in the policy rate today."

The markets had been expecting a rate cut and had started to factor its positive impacts in the stock prices even before June 2. See figure 1 below. 

                          

The market had moved up by 1.37% on May 29th, 2015 and remained flat on June 1st, in anticipation of a rate cut. However, in spite of the rate cut on June 2nd, the NIFTY fell by 2.36% and continued its downward trend for the next five trading days.

Why did this happen?
This happened because of the cautious stance of the RBI. The fall in stock prices was because the investors had already expected the third repo rate cut this year and had factored it in, anticipating, in fact, a 50 basis points repo rate cut.

The uncertainty with regards to monsoons which may result in food inflation if not managed properly by the government, rising crude prices amidst considerable volatility and geopolitical risks, and volatility in the external environment, were cited as the reasons for a 25 basis point rate cut rather than a 50 basis point rate cut.

Therefore, overall guidance from RBI was not that of a ‘cheer leader’.

Rate cut again

RBI’s various statements and interactions with the media indicate that further rate cuts in the near future is unlikely. However, with inflation figures expected to be well within RBI’s target, there may be room for further rate cut. Though, RBI would be watching the monsoon and crude oil prices like a hawk before any decision is taken!
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