We received a query regarding the Fed cut and its possible impact on the Indian Economy. So we are posting a response to this question. Any doubts regarding this topic, you may ask us immediately.

Interest Rates and their Role

A Basis Point is 1/100th of of one percent. A Basis Point is generally used in reference to interest rates and additions or subtractions done to interest rates. To put it simply if a central bank changes interests rates by 75 basis points, it means that the change is of 0.75%.

Now, let us see what are interest rates. Suppose you have a certain amount of money. Now you want to lend it to someone. To do that, u have to let go of some things you could have done with that money. Eg – with Rs 10,000 you might have wanted to add some accessory to your PC, but now since you will lend that money, you will have to forget it for some time. So you will demand some price of it, won’t you? This price is the interest rate which the lender gets from the borrower. If you charge an interest rate of 10% on Rs. 10,000 annually, you will get an additional interest payment of Rs. 1,00o(10% of Rs. 10,000).

Now think of a lender and borrower in an economy. Where does the money come from? In India, it is the Reserve Bank of India that prints money. It gives that money to banks who further lend it to end-consumers like you and me. That is how money simply flows in an economy. Now RBI gives the money to banks at a certain?? – yes, interest rate. The banks in turn lend it to consumer at a higher interest rate to earn profit.

Now a central bank has to keep in balance a lot of things. It has to keep prices in an economy under control – i.e. inflation, It has to maintain a favourable Exchange Rate, and finally it has to to maintain all the conditions of growth intact.

It does it through many instruments, one of which is controlling interest rates. Now, what reductions or increases of interest rates do to an economy. Lets have a look.

If you INCREASE the interest rates, that means the money in the economy will be available at a HIGHER cost. This means that the demand of money will be LESSER, because, as a borrower, one will have to shell out extra money as interest. Simple rule of demand. When price of anything increases, its demand decreases. So people will demand lesser money, (simply put, people will have lesser money in their hands) which will in turn, reduce the demand of general goods and services in the economy. And as an effect, the prices of these goods and services decrease because of the lower demand.

So the cycle goes like this:

Increase Interest Rate – Money becomes costlier-Lower demand of money-Lower demand of goods and services- Lower prices of goods and services- Lower inflation

Also, higher interest rates will attract investment in the form of capital flows into a country which will have its effects. We will come to that later

Now, a central bank would INCREASE interest rate when a country is facing high inflation. Pretty simple isn’t it?

On the other hand – if you DECREASE interest rates, money in an economy would become CHEAPER. So people will demand MORE money and thus MORE goods and services, which will increase prices of goods and services i.e. increase inflation.

This cycle goes:

Decrease Interest Rate – Higher demand of money-Higher demand of goods and services- Higher prices of goods and services- Higher inflation

Again lower interest rates would make the investment go out of the economy in the form of capital outflows. And again, a central bank would reduce interest rates when the economy is in the state of deflation or lower activity in the economy. I hope it clears the concepts. Any doubts, shoot a question.

Fed Cut and its impact

Now that we have understood what interest rates are and why do central banks reduce or increase them, we come to your specific question of Fed cuts and its implication on us.

Well, Fed is the central bank of United States (short form of Federal Reserve). A fed cut would mean that the Federal Reserve has cut the interest rate.

Now why has fed done so? This is because the US economy is in a state of slowdown. Prices are falling, so is dollar and the consumption demand in the economy is falling. To mend this situation, the Federal Reserve has taken this step to reduce the interest rate. This is expected to increase the demand for money and increase the demand for consumption of goods and services and help the economy fight recession/slowdown.

As far as impact on us in concerned, I would bring in the discussion of capital flows that we touched upon earlier.

Now in the global economy, there are investors who have money with them and they are looking at investment options all around the world. So they invest where they see higher returns. Now picture this:

In the US, interest rates are lower. In India, interest rates are higher. As an investor, if you have two options- in the U.S you investment fetches you 4% and in India, you get 9%. Where would you invest? Yes, of course –India

So what is happening is that a lot of dollar is flowing into India – which is doing two things – Raising the value of the rupee in dollar terms and of course our stock market indexes are rising.

So that, in a nutshell, is the impact on us. But in the long term, the impact on India will depend upon RBI’s response. The RBI has to keep its own things in mind- like Inflation. If it keeps the rate intact, capital inflows will increase because the rates in the US are falling.

And of course, capital inflows have their own impact on exchange rate and inflation etc.

We hope this makes it a bit clearer.