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Fundamentals - Financial markets - Fiscal and monetary policies (A central…
Fundamentals - Financial markets - Fiscal and monetary policies
A central bank always has a tough job on hand to change the economics of money. That is demand for/supply of money.
One wrong decision by a central bank will change the fate of a financial market in the short term.
An economy's financial sector, of which financial markets are a part of, is always in the focus of global investors (real money). They observe how the dynamics of money and goods/services are changing, so that they can make money and avoid risks based on these news.
This is where a central banker's rate decision assumes superior importance in the global markets. This applies to India as well.
So what is a central bank doing when it is giving a decision on a frequent basis.
So at every monetary policy meeting, the board of a central bank (which comprises top economists, business men and policy makers) meets and takes a decision to either increase or decrease the cost of money, which is the interest rate.
Financial markets are the key link between the financial sector and the real economy. They enable the supply or demand of money on both sides.
Financial markets are like the link between the dumbbells (one is the real economy with both consumers and producers and the other one is the financial sector with both consumers and producers).
In an economy, there are many types of interest rates. Rates charged by banks to consumers (corporates and individuals). But where do banks get money? They get money from two sources: (1) central bank, which is the lender of the last resort; (2) money market, which is a market for exchanging money in the short term.
The interest rates range from micro term to long term. These rates are driven by the rates at the short end of the curve, which is the repo and reverse repo rates set by the Central bank.
A bank rate or a Fed funds rate is the rate that is set by the central bank to indicate the minimum rate that banks can start exchanging with. So this is one of the tools at a central bank's disposal.
Another tool is the rates that control the money flow in the financial sector. These are the repo or reverse repo rates, which are formed by exchange of government securities with the central banks.
So if a bank wants money, it can buy or sell gilts from the market. Similarly the central bank will repurchase (repo) government securities from banks to give them money.
GIlts are issued by the central bank on behalf of the government, which is taking a loan through gilts. That is why they are called government securiities.
Because gilts are guaranteed by the government most banks will have gilts in their portfolios, where they park their surplus cash. Now whenever they want money they go through a repo, where the central bank buys back the gilts and gives money to the required bank. A reverse repo will infuse gilts bank into banks and take away money from the financial system. That is why in India RBI uses repo and reverse repo as the benchmark rates.
But the US Fed uses the Fed funds rate, which is the rate charged by banks to each other to lend or take money. Our benchmark monetary policy rate is different from that of the Fed.
Every central bank has various types of interest rates based on the structure of their economies. They keep changing what is the apt policy rate for them. Currently, for India, repo rate is the policy rate. Earlier it was bank rate.
In India, we have a call money market, where funds are exchanged by banks on a daily basis to meet the demand and supply of money for them to do their business.
Banks participate in this online call money market daily to lend or take money at market levels. RBI will be monitoring this market to keep the tabs on the financial sector.
RBI board meets at preset frequent intervals to decide what is the right REPO RATE for the economic conditions during that review period, This sets the tone for the financial sector and markets. Hence observing a central bank policy is important for a trader.
Whenever there is an RBI policy, Nifty, Bank Nifty and financials generally mover berserk.