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Why interest rates change
When interest rates change, it is the result of many complex factors. People who study interest rates find that it is as difficult to forecast future interest rates as it is the weather. Since interest rates reflect human activity, a long-term forecast is virtually impossible. After the fact, explanations are many and confident! Some of the major factors which help to dictate interest rates are explained below. Supply and Demand for Funds Interest rates are the price for borrowing money. Interest rates move up and down, reflecting many factors. The most important among these is the supply of funds, available for loans from lenders, and the demand, from borrowers. If the demand for borrowing is higher than the funds they have available, they can raise their rates or borrow money from other people by issuing bonds to institutions in the "wholesale market". The trouble is, this source of funds is more expensive. Therefore interest rates go up! If the banks have lots of money to lend and the housing market is slow, any borrower financing a house will get "special rate discounts" and the lenders will be very competitive, keeping rates low. Monetary Policy Another major factor in interest rate changes is the "monetary policy" of governments. If a government "loosens monetary policy", this means that it has "printed more money". Simply put, the RBI creates more money by printing it. This makes interest rates lower, because more money is available to lenders and borrowers alike. If the supply of money is lowered, this "tightens" monetary policy and causes interest rates to rise. Governments alter the "money supply" to try and manage the economy. The trouble is no one is quite sure how much money is necessary and how it is actually used once it is available. This causes economists endless debate. Inflation Another very important factor is inflation. Investors want to preserve the "purchasing power" of their money. If inflation is high and risks going higher, investors will need a higher interest rate to consider lending their money for more than the shortest term. After the very high inflation years of the 1970s and early 1980s, lenders had to receive a very high interest rate compared to inflation to lend their money. As inflation dropped, investors then demanded lower rates as their expectations become lower. Imagine the plight of the long-term bond investor in the high inflation period. After lending money at 5-6%, inflation moved from the 2-3% range to above 12%! The investor was receiving 7% less than inflation, effectively reducing the investor's wealth in real terms by 7% each year! What is Bank rate? Bank Rate is the rate at which central bank of the country ( Bank Rate in India is decided by RBI) allows finance to commercial banks. Bank Rate is a tool, which central bank uses for short-term purposes. Any upward revision in Bank Rate by central bank is an indication that banks should also increase deposit rates as well as Base Rate / Benchmark Prime Lending Rate. Thus any revision in the Bank rate indicates that it is likely that interest rates on your deposits are likely to either go up or go down, and it can also indicate an increase or decrease in your EMI.

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What is CRR? or What is CRR Ratio : The Reserve Bank of India (Amendment) Bill, 2006 has been enacted and has come into force with its gazette notification. Consequent upon amendment to sub-Section 42(1), the Reserve Bank, having regard to the needs of securing the monetary stability in the country, RBI can prescribe Cash Reserve Ratio (CRR) for scheduled banks without any floor rate or ceiling rate ( [Before the enactment of this amendment, in terms of Section 42(1) of the RBI Act, the Reserve Bank could prescribe CRR for scheduled banks between 3 per cent and 20 per cent of total of their demand and time liabilities]. RBI uses CRR either to drain excess liquidity or to release funds needed for the growth of the economy from time to time. Increase in CRR means that banks have less funds available and money is sucked out of circulation. Thus we can say that this serves duel purposes i.e.(a) ensures that a portion of bank deposits is kept with RBI and is totally risk-free, (b) enables RBI to control liquidity in the system, and thereby, inflation by tying the hands of the banks in lending money. What is SLR? : Every bank is required to maintain at the close of business every day, a minimum proportion of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold and un-encumbered approved securities. The ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio (SLR). RBI is empowered to increase this ratio up to 40%. An increase in SLR also restrict the banks leverage position to pump more money into the economy. What are Repo rate and Reverse Repo rate? Repo (Repurchase) rate is the rate at which the RBI lends shot-term money to the banks against securities. When the repo rate increases borrowing from RBI becomes more expensive. Therefore, we can say that in case, RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate. Reverse Repo rate is the rate at which banks park their short-term excess liquidity with the RBI. The banks use this tool when they feel that they are stuck with excess funds and are not able to invest anywhere for reasonable returns. An increase in the reverse repo rate means that the RBI is ready to borrow money from the banks at a higher rate of interest. As a result, banks would prefer to keep more and more surplus funds with RBI. Repo rate is 8% at present. From banks point of view, Repo arrangement with the RBI is like a common man taking a short term loan from a bank. Liquidity adjustment facility (LAF) is a monetary policy tool which allows banks to borrow money through repurchase agreements. LAF is used to aid banks in adjusting the day to day mismatches in liquidity.LAF consists of repo and reverse repo operations Overall Impact of RBI measures: 1) Due to Change in Interest Rates: Overall interest rate environment affects the demand for goods and services. Higher interest rates make it more attractive to save and lead to a reduction in household consumption. It also makes it more expensive for firms to finance investment. If both consumption and investment fall, it leads to a fall in aggregate demand and resource utilization. It results in prices and wages rise at a more modest rate.

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2) On Inflation Expectations: Due to reasons mentioned above like lower household consumption and lower corporate investments, a tighter monetary policy should result in lower inflation as it reduces the aggregate demand 3) On Exchange Rates: Normally, an increase in the interest rates should result in a strengthening of the Indian rupee. This is because higher interest rates make Indian assets more attractive from a foreign investors point of view. The result is a capital inflow and increased demand for rupee, which strengthens the exchange rate. The consensus this time is that the near drought condition has made RBIs situation trickier than before and they are between a rock and a hard place. The policy announcement tomorrow will be interesting, and if they make any rate changes that will be even more interesting and even a little surprising. Apart from the CRR, banks are required to maintain liquid assets in the form of gold, cash and approved securities. Higher liquidity ratio forces commercial banks to maintain a larger proportion of their resources in liquid form and thus reduces their capacity to grant loans and advances, thus it is an anti-inflationary impact. A higher liquidity ratio diverts the bank funds from loans and advances to investment in government and approved securities. In well-developed economies, central banks use open market operationsbuying and selling of eligible securities by central bank in the money marketto influence the volume of cash reserves with commercial banks and thus influence the volume of loans and advances they can make to the commercial and industrial sectors. In the open money market, government securities are traded at market related rates of interest. The RBI is resorting more to open market operations in the more recent years. Generally RBI uses three kinds of selective credit controls: 1. Minimum margins for lending against specific securities. 2. Ceiling on the amounts of credit for certain purposes. 3. Discriminatory rate of interest charged on certain types of advances. Direct credit controls in India are of three types: 1. Part of the interest rate structure i.e. on small savings and provident funds, are administratively set. 2. Banks are mandatory required to keep 24% of their deposits in the form of government securities. 3. Banks are required to lend to the priority sectors to the extent of 40% of their advances. RBI Monetary Policy Update: RBI leaves Repo and Reverse Repo rates unchanged at 8% and 7% respectively, to keep inflation under check; cuts SLR by 1% from 24% to 23% in order to ease liquidity. GDP growth forecast has been lowered to 6.5% from 7.3% earlier and inflation forecast has been raised to 7% from 6.5% earlier.

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For Further Details kindly Contact: Thanks and Regards, Kirang Gandhi Independent Financial Planner www.fpindia.in M- 9028142155