Federal Rate Cut Implications

The US fed unexpectedly cut the Fed Fund rate and the Discount rate by 50bps to 4.75% and 5.25% respectively in the FOMC meeting held on the 18th of September. This caused markets globally to move up sharply. Both the BSE Sensex and the Nifty were up by 4% the next day in reaction to the cut in the fed rates. The BSE Sensex was up by 654 points while the Nifty was up by 186 points. The table below depicts the movement of various global indices immediately after the fed rate cut.

Index
Absolute Change
% change
FTSE
177
2.81%

Hang Seng
978
3.98%

Nikkei
580
3.67%

Russia
77
3.96%

KOSPI
64
3.48%

Dow Jones
336
2.45%

As can be seen from the table above the cut in the fed rate along with the discount rate helped change the sentiment in the equity market. The cut in the fed rates widened the interest rate differential between the US and other markets. With the cut in the fed rate the overall liquidity situation has improved. Most of the liquidity flows has been to emerging economies as they offer higher growth rates as compared to developed economies. The Fed Rate cut opened up the floodgates as foreign money poured into the Indian stock market. FII’s were net buyers to the extent of $ 2.96bn during the period. The total FII investment in India for year 2007 till date stands at $ 12.2bn as compared to a total inflow of $ 8bn for full year 2006.

The key implication of the cut in the Fed Rate is that both banks and corporate could borrow at cheap rates to meet their reserve requirements. Since August 17th the US Fed has cut the discount rate by 100bps. The Discount rate is the rate at which the US Fed provides money to the banks. The cut in the discount rate would help banks who have been shut out from the open markets to source funds from the US Fed. With the aggressive cut in both the rates the US Fed has sent a signal that it would help genuine need for money that would not be hampered due to rising costs. The reason for the aggressive cut in the fed rate and an even more aggressive cut in the discount rate has been the turmoil in the credit markets as the secondary credit market had come to a standstill due to losses in Collaterized Debt Obligations (CDO’s) backed by US subprime mortgage. The concern of slowdown in US GDP growth on account of a slowdown in the housing market might also have led to this rate cut.

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