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Tata Capital > Blog > Wealth Services > How And Why Does Monetary Policy Impact Equity Markets?

Wealth Services

How And Why Does Monetary Policy Impact Equity Markets?

How And Why Does Monetary Policy Impact Equity Markets?

Monetary policy is one of the tools used by RBI to control the money supply in the economy by altering the interest rate. The interest rate is adjusted consistently to strike a balance between growth and inflation. Now, how could monetary policy possibly impact equity markets? Here’s how:

How does monetary policy help economic growth?

In the event that interest rates are rising, the borrowing rate becomes quite high. This creates stress on industries, they cannot borrow easily and struggle to match their existing interest payments. It slowly starts to squeeze their margins. Their inability to borrow at competent rates only leads to them being unable to grow their business. This leads to a gradual slowdown in the economy. With short supply and greater demand for products, the price of products tends to rise, leading to inflation.

On the other hand, borrowing becomes easier if the interest rates are low. More companies and investors start to borrow money at lower interest rates. This leads to better productivity from a corporate perspective. While the industry continues to flourish under this condition, people are wary of putting their money in low–yielding instruments. Although there may be increased spending initially, the sellers to cash in on the situation tend to raise the prices, leading to inflation.

Clearly, this is a catch-22 situation and RBI must strike the right balance between the two scenarios by adjudging the right interest rate. This is achieved by tweaking the money supply in the economy. The tools that RBI uses to achieve the intended economic growth are:

  1. Repo Rate:
    This is the rate at which RBI lends money to other banks, by increasing this rate, the subsequent interest rate offered on loans by the bank would automatically increase.

  2. Reverse report rate:
    This is the rate at which RBI borrows money from banks. Due to the lower default risk, the banks prefer to lend to RBI, thus lowering the money supply with banks for other banking activities.

  3. Cash Reserve Ratio:
    Every licensed bank is required to maintain funds with the RBI. By increasing the CRR, the RBI is able to curb the money supply with the banks for lending activities. 

The RBI reviews the rates once every 2 months. It is a very important event that impacts the entire economy including the capital markets. Here’s how it impacts the Indian stock market.

Impact of monetary policy on the Indian stock market

It is quite apparent from the above that monetary policy has a direct impact on the interest rates, there are sectors which are directly impacted by the revision of monetary policy – banks, NBFCs, housing finance, automobiles, real estate and other high-lever companies (debt-heavy). They are the first ones to react to the RBI monetary policy. If the revision is perceived favorably in the economic conditions, then you can see the stocks march ahead, on the contrary, they may slip sharply depending on the extent of the foreseeable damage. 

However, it is often seen that there is a round of expectations which is discussed actively among experts and the investor community. If the RBI’s announcement pans out as expected, then there may be no noticeable reaction in the market. This is primarily because the stocks have already factored in the perception/expectation.

From the above discussion, it was quite apparent that the policy changes also affect the money supply, which essentially means that the spending pattern is affected. Every company thrives on the spending pattern in the economy. Spending is by far the most important aspect that enables the economic dynamics to play out. When the money supply is low, then the spending comes down, this means that the companies are unable to sell their inventory. The supply is more, while the demand is on the lower end, pushing the prices down. Thus, leading to a curb in inflation. This also means that its revenue growth is affected, leading to a slump in its stock prices. The contrary happens when the money supply is intact. This is specifically true in the case of discretionary spending.

Often, sectors like FMCG, and Pharma remain relatively unaffected despite the change in the money supply. These sectors are the last to fall when the markets start to crumble under a stiff macro environment. 
We hope this article, gave you a definite idea of how monetary policy affects your portfolio. It should help you design your portfolio such that it weather’s through any intermediate storm. You can seek help from our experts at TATA CAPITAL who will help you design a portfolio which not only aligns well with your risk-return profile but also stays strong across all macroeconomic environments.

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