Focus: Fed Funds Rate

Everyone in the market is expecting a cut in the target fed funds rate by Federal Reserve. This is the rate that Federal Reserve will try to achieve in the inter-bank borrowing market in US.

The futures on the t-bills can provide indicative market sentiment and expectations towards changes in future rates. The option contract on t-bills futures on C-bot (Chicago board of trade) can even provide the probability how much the market is pricing in a rate cut. Assuming there is a close relationship between fed funds rate and t bills rates.

If federal reserve cuts rates below to below 50bps then that will be the lowest rate since world war 2. Already market expectation of 75 bps cut was showing a probability of close to 90% week back, but one day before the cut has come down to 50-60%. What is more shocking that there is a 20% probability that the federal reserve will cut the Fed funds rate down to 0%. The effective federal funds rate on the futures market has fallen near zero as well -- as low as 0.0625 percent -- despite the Fed target of 1.0 percent.

Rate cuts do boost the economy, but there are times when rate cut do not really lead to economic growth, this is due to deflation (-ve inflation). During times of deflation even though the interest rates might be close to zero but real interest rates which is the difference between interest rates and inflation could end up being really high, making borrowing less attractive. At the same time there is a decline in the investments due to negative time value to money; money in future is more valuable that money now, so by just keeping money idle under the bed would generate a return!

The rate cut I believe is just a cosmetic measure to be taken by Federal Reserve even though it is occupying lot of media space. What I believe is more important are the measures to be taken by the government to boost spending and economic growth. That would be the true solution to the worst global economic period since great depression!

i-rates & Monsoonomics

Latest annual inflation figure for the week ending 21st April came out at 5.77 percent, lower than the expected 5.87 percent. It was lower than the previous months figures of 6.09 percent. The RBI in its annual policy set inflation target of around 4 to 4.5 percent, which seemed impossible. The Finance minister commented that the monetary measures of the government before the policy are the reasons for the decline in the inflation rates. Last week RBI was very confident that there was no need to revise the key monetary rates, the Repo rates and the Reserve ratios.

The RBI must also be good at predicting the weather. Commodity prices like pulses and other agricultural commodities were the main culprits behind the burgeoning inflation. A good monsoon along with bumper crop could actually solve the problem related to inflated food prices. The RBI must have predicted a low inflation on the basis of good expected crop or in other word good expected monsoon.

This gives new twist to the “internationally popular” fisher’s formula. Which says that nominal interest rates are just and addition of real interest rates and expected inflation. Now at-least in Indian context the economists have to also include Expected monsoon next to Expected inflation to perfect the equation.

Read other articles related to inflation on the blog by clicking at the tags placed at the end of the article.

Annual Policy: Surprise

It was widely accepted that the RBI would increase its rates in its annual policy. Many economists were predicting at least 25 basis points increase in the Repo rates. But the RBI kept its policy rates unchanged; Repo Rates at 7.75%, and Reverse Repo and Bank Rate at 6.00%. Also CRR and SLR were untouched at 6.25% and 25%.

The policy also motioned to curb inflation into a range of 4.0% and 4.5% from the current level of just above 6%. Just recently at a lower level of inflation the RBI increased rates to keep inflation under control. But it resulted in only Rupee appreciating to its highest level for last (aprox 10 years). Rupee so far is the best performer amongst the Asian currencies, appreciating about 15% from lows of around 47.04 in July last year. The RBI was letting the Rupee appreciate with the logic that Rupee appreciation would cut down inflation, by lowering the cost for imports. The higher Rupee is actually hurting the small exporters who were unable to hedge their Forex positions.

But RBI clearly stated in the policy that the affect of currency appreciation on Inflation rates is minor. So it looks like the RBI has no concrete measures to cut down the inflation apart from praying for lower price levels. Main source of increase in the WPI is higher Food commodity prices and infrastructural commodities like cements and steel. A good monsoon (for agricultural commodities) and calm Middle East (for crude oil prices) would help in achieving this.

Meanwhile the Nifty soared to new highs at 4167.30 up from 4141.80 showing a 0.62% increase. Till afternoon the Nifty was showing a downward trend on the back of NIKKEI in Japan which closed -1.24% lower at 17236.16.

Interest Rates Rising

US FED Reserve had been constantly hiking interest rates due to high inflation fuelled by the heating up of commditities prices. And Globaly central banks were trying to match US FED by doing the same. In India also RBI started taking a harder stance by revising the REPO and Reverse REPO rates. Last month the rates were increased by 25 basis points. This has lead to increase in the cost of borrowings of commercial banks who are passing this on to their clients by revising their lending rates.

It is quite evident that since the rate of interest goes higher it will impact the sectors of economy that are dependent on interest rates, like the housing sector. To some extent the housing real estate boom in India was related to the cheap housing loans offered by banks. Still finace minister P Chidambaram believes that the interest rate hike is very moderate and it will not affect the booming housing sector.

The government is trying to do its best to not allow the interest rates to hamper the growth of our economy. The cost of borrowings of the Indian companies has increased in recent times which might affect profitability. The govt. is trying its best to keep a balance by hiking the interest rates to control inflation (abt 5%) and at the same time trying to keep the cost of borowings down by infusing liquidity through reduction of CRR ratio to 5%.

It is very clear that the govt. supports high growth rate of GDP, and in order to maintain this they are trying to keep cost of borrowing low. They are also asking the PSU banks to not hike their PLR(Prime lending rates) in accordance with the market.

SBI Margins Improve but Q1 net falls

SBI reported a net interest margin of 3.37 percent comparede with 3.14 percent a year earlier, adjusting for one-time income. The margins improved because of the decline in the cost of deposits to 4.47 from 4.82 a year earlier and its average yield on loans rose to 8.49 percent from 7.80 percent. The Net interest income fell 8.7 percent to Rs. 38.84 bill from 42.53 bill. This is mainly due to lower income from treasury operations. The central bank is aiming to keep inflation in a 5 to 5.5 percent range and raised the short-term interest rates by 25 basis points earlier this week to 6 percent.

The central bank is projecting a growth rate of 20 percent for the year to March 2007 so bankers see more rate increases ahead if loan growth shows no sign of slowing. The SBI is more bullish by aiming for 25% loan growth for the year. SBI holds more than third of its deposits in government bonds, suffered a 20 percent fall in the treasury revenue to 36.06 billion rupees form 45.24 billion a year earlier as bond yields rose 60 basis points in the April-June quarter. The shares of SBI valued at $8.4 billion dropped by almost 25 percent in April-June, underperforming a near 6 percent fall in Sensex.