Rate Cut
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A rate cut is a reduction in the interest rate at which the central bank of a country conducts its transactions. This interest rate forms the benchmark rate for all inter-bank loan transactions. Decisions regarding rate cuts are taken by the governing body of central banks. The main purpose of this measure is to regulate the money supply in an economy. However, this nominal rate is just a guideline. The actual rate is determined by open market operations where the banks negotiate the lending rate on an individual basis.
A rate cut is a reduction in the interest rate at which the central bank of a country conducts its transactions. This interest rate forms the benchmark rate for all inter-bank loan transactions. Decisions regarding rate cuts are taken by the governing body of central banks. The main purpose of this measure is to regulate the money supply in an economy. However, this nominal rate is just a guideline. The actual rate is determined by open market operations where the banks negotiate the lending rate on an individual basis.
Rate Cut: How it Works
Rate cuts encourage banks to borrow more from other financial institutions. Such borrowings boost the final lending capacity of a bank. The banks then pass the benefit of rate cuts to individual customers by lending at a lower interest rate.
Rate cuts enhance the availability of credit, boosting economic growth. A rate cut is often implemented to prevent the economy from slumping. However, when an economy is going through an inflationary phase, rates are increased to contain the supply of money in the market.
Rate Cuts: Implications for Investors
A central bank’s decision to introduce a rate cut must be taken into account by investors.
The relationship between rate cuts and the stock market is indirect and they usually move in opposite directions. This is because a rate cut is favorable for those who wish to borrow funds. Businesses are encouraged to finance their expansion plans. This boosts their potential earnings, leading to an upward movement in stock prices.
On the other hand, a rate cut would adversely impact the opportunity to earn from bonds. Thus, a rate cut is usually followed by a transfer of funds by investors from the bond market and into the equity market.
Rate cuts also impact mortgages, as it becomes cheaper to finance homes, with a decline in adjustable-rate mortgage payments. Moreover, people are encouraged to use their credit cards, as the interest charged on those with variable rates declines.
At a broader level, an interest rate cut has a psychological impact on consumers and investors, who perceive it as favorable for the economy in general.
