Posts Tagged ‘discount rate’

Factors that Move the Interest Rates – Part 2 (MONETARY POLICY)

Monetary Policy

In previous Blog we have discussed about the major factors responsible for the change in interest rates and price of bonds indirectly.

All those three factors like Inflation, Currency and Liquidity have been touched upon in last blog.

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Now time to look into another major factor which causesΒ  movement in the interest rate. The factor i am talking about is Monetary Policy. πŸ™‚

Monetary Policy: The RBI controls liquidity largely through monetary policy instruments –

(i) CRR & SLR – CRR (Cash Reserve Ratio) refers to a portion of deposits (as cash) which banks have to maintain with the RBI.

Banks are also required to invest a portion of their deposits in government securities as a part of their SLR (Statutory Liquidity Ratio) requirements.

If either of these is increased, liquidity tightens and so interest rates harden (increase).:(

Recently, RBI has reduced both these rates to infuse liquidity in the system – CRR is 5% (down 250 bps from March ’08) and SLR is 24% (down 100 bps).

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(ii) Reverse repo rate – it is the overnight interest rate that a bank earns for lending money to the RBI in exchange for G-Secs.

A hike in reverse repo rate increases interest rates. Currently, reverse repo rate stands at 3.25%.

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(iii) Repo rate – it is the discount rate at which a central bank repurchases government securities from the commercial banks.

To temporarily expand the money supply, the central bank decreases repo rates (so that banks can swap their holdings of government securities for cash).

To contract the money supply, it increases the repo rates. The current repo rate is 4.75%.

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(iv) OMO and MSS – OMOs (Open Market Operations) are outright transactions in government securities.

When the RBI buys G-Secs, it is injecting money into the system, hence, increasing liquidity, which softens (reduces) interest rates.

When the RBI sells G-Secs, it sucks out excess money from the system i.e. reduces liquidity in the system which hardens interest rates.

MSS (Market Stabilisation Scheme) is the issuance of treasury bills and dated securities by way of auction by the RBI.

This affects interest rates in the same manner as OMOs.

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Having collected updates on where the above parameters stand, one can have a better understanding of why interest rates are at their current levels, as well as which direction they are expected to move in.

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If most of them indicate that a rise in interest rates is expected, bond prices are likely to fall in the future.

On the contrary, an expectation of a fall in interest rates means bond prices will rise.

A word of caution here though – timing interest rate changes is difficult. This is because there is a low likelihood of being able to precisely predict the movement in the factors discussed above.

So in order to minimize interest rate risk, one should ensure that the bond portfolio is diversified across various maturities.

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4 Monetary Policy: The RBI controls liquidity largely through monetary policy instruments –

(i) CRR & SLR – CRR (Cash Reserve Ratio) refers to a portion of deposits (as cash) which banks have to maintain with the RBI. Banks are also required to invest a portion of their deposits in government securities as a part of their SLR (Statutory Liquidity Ratio) requirements. If either of these is increased, liquidity tightens and so interest rates harden (increase). Recently, RBI has reduced both these rates to infuse liquidity in the system – CRR is 5% (down 250 bps from March ’08) and SLR is 24% (down 100 bps).

(ii) Reverse repo rate – it is the overnight interest rate that a bank earns for lending money to the RBI in exchange for G-Secs. A hike in reverse repo rate increases interest rates. Currently, reverse repo rate stands at 3.25%.

(iii) Repo rate – it is the discount rate at which a central bank repurchases government securities from the commercial banks. To temporarily expand the money supply, the central bank decreases repo rates (so that banks can swap their holdings of government securities for cash).

To contract the money supply, it increases the repo rates. The current repo rate is 4.75%.

(iv) OMO and MSS – OMOs (Open Market Operations) are outright transactions in government securities. When the RBI buys G-Secs, it is injecting money into the system, hence, increasing liquidity, which softens (reduces) interest rates. When the RBI sells G-Secs, it sucks out excess money from the system i.e. reduces liquidity in the system which hardens interest rates. MSS (Market Stabilisation Scheme) is the issuance of treasury bills and dated securities by way of auction by the RBI. This affects interest rates in the same manner as OMOs.

Having collected updates on where the above parameters stand, one can have a better understanding of why interest rates are at their current levels, as well as which direction they are expected to move in. If most of them indicate that a rise in interest rates is expected, bond prices are likely to fall in the future. On the contrary, an expectation of a fall in interest rates means bond prices will rise. A word of caution here though – timing interest rate changes is difficult. This is because there is a low likelihood of being able to precisely predict the movement in the factors discussed above. So in order to minimize interest rate risk, one should ensure that the bond portfolio is diversified across various maturities.

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