19th September 2007, 09:08 AM
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Sachin Asher
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Join Date: Sep 2006
Location: Vadodara
Posts: 8,636
Rep Power: 383
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This is US's final line of defense.
The fed has done two things:
It has reduced the federal funds rate from 5.25% to 4.75%.
It has also reduced the discount rate from 5.75% to 5.25%.
Federal funds rate is the rate at which banks borrow from each other.
Discount rate is the rate at which banks borrow from the Federal Reserve.
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Lowering the interest rates means there is more money in the system. More money means it is easier to borrow and economic activity gets a boost.
Lowering the interest rates also means that, compared to bonds, stocks become more attractive than earlier.
These were the two reasons why US stocks shot up.
When a country lowers it interest rates. its bonds become less attractive. Investors want bonds that offer higher interest rates and thus look at other countries' bonds. Capital flows out of the country and into those countries that offer better interest rates. Thus the decline in dollar against other currencies.
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What does it mean for India?
Actually nothing much. Indian bonds get slightly more attractive compared to US bonds and this means more capital flows in. If the dollar weakens, exports to US become difficult. If US economy does better, then exports may increase a bit again. Net-net not much effect.
The key question here is, will the federal rate cut solve US's economic problems?
I don't think so. The rate cut may take a few quarters to show positive effects on the US economy. Also inflation has become a great cause of concern. Crude oil prices are at all-time-highs and prices of food items are rising fast too. In fact, wheat prices are also at an all-time-high.
Softer rates mean greater money supply and thus greater inflation. This inflation may not allow the fed to cut rates further. In fact, an out-of-control inflation may force the Federal Reserve to again hike rates in the future.
In my opinion, by cutting interest rates, US is just delaying a recession that stands at its doorstep.
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