Monetary Policy and Stock Markets

Category : NCFM-Capital Market

15th Feb, 2012, Ashish Pandey-Intelivisto

Monetary Policy is the actions of a central bank that determine the size and rate of growth of the money supply, which in turn affects interest rates. It is one of the ways that the government attempts to control the economy. If the money supply grows too fast, the rate of inflation will increase; if the growth of the money supply is slowed too much, then economic growth may also slow.

When is the Monetary Policy announced?

The Monetary Policy has become dynamic in nature as RBI reserves its right to alter it from time to time, depending on the state of the economy. The Governor of the Reserve Bank announces the Monetary Policy in April every year for the financial year that ends in the following March. This is followed by three quarterly reviews in July, October and January. However, depending on the evolving situation, the Reserve Bank may announce monetary measures at any point of time.

A policy is referred to as contractionary if it reduces the size of the money supply or increases it only slowly, or if it raises the interest rate. An expansionary policy increases the size of the money supply more rapidly, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation.

Inflation refers to a persistent rise in prices. Simply put, it is a situation of too much money and too few goods. Thus, due to scarcity of goods and the presence of many buyers, the prices are pushed up.

Inflation rate is the measure of the rate of change of price and not the absolute change in price. Which means till inflation rate comes down to zero prices will continue to rise. It is inflation rate goes negative will prices fall. The comment about inflation rate going down only implies that the prices of food will not increase as fast as it was in the last few months, which does not imply that the prices are not increasing.

A tool to control inflation, which directly affects interest rates

Monetary policy is aimed at controlling the level of inflation & interest rates in the economy. To do that, the Reserve Bank tries to lower the money supply when prices are rising. How does it do that? By lowering the amount of money available with banks. Raising reserve requirements, i.e., the amount of money which banks must keep impounded with the RBI is one way. Another method is to sell bonds to the banks. When banks buy bonds from the RBI, money flows out from banks to the RBI, lowering the amount of money available for lending.

In times of inflation, RBI sells securities to mop up the excess money in the market. Similarly, to increase the supply of money, RBI purchases securities.

So by changing the money supply, the Reserve Bank can determine the level of interest rates. Higher levels of interest rates impact corporate bottom lines and discourage companies from investing. That slows down growth.

The fact is that RBI monetary policy has an effect on all investors. Let's take a look how.

The stock markets and money move similarly, in some ways. Why?

Most people attribute the link between the amount of money in the economy and movements in stock markets to the amount of liquidity in the system. This is not entirely true.

The factor connecting money and stocks is interest rates. People save to get returns on their savings. In true market conditions, this made bank deposits or bonds (whose returns are linked to interest rates) and stocks (whose returns are linked to capital gains), competitors for people's savings.

The markets, however, move to the RBI's tune because of the link between interest rates and capital market yields. The RBI's policies have maximum impact on volatile foreign exchange and stock markets. A hike in interest rates would tend to suck money out of shares into bonds or deposits; a fall would have the opposite effect.

Impact on stock market

In the West, where both the bond as well as the equity markets are mature, an increase in interest rates leads to more money flowing into bonds. Other things remaining the same that means less money for the equity markets. In India, the bond markets are not very much developed, and only the banks and primary dealers are active in that market. Since banks do not invest in equities, except marginally, there is no flow of funds from the bond to the equity markets. So the impact of monetary policy on the equity markets here is indirect, rather than through the direct route.

However, the RBI does have a more direct way of influencing the stock market. That is by varying the percentage of funds which banks are allowed to invest in the stock market. At present, the aggregate exposure of a consolidated bank to capital markets (both fund based and non-fund based) should not exceed 40 per cent of its consolidated net worth as on March 31 of the previous year.

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