Reason: Factors that prevented banks from lowering their loan rates have remained quite strong.

These include piling up of bad and restructured loans, weak earnings growth and poor capital
position of state-run banks. anks wanted to repair their balance sheets by cutting down bad debt,
before further expanding their loan book, by attracting fresh borrowers offering cheaper loan
rates.
Secondly, high provisions on bad loans and low demand for loans have put pressure on their
earnings and any significant cut in lending rates at this stage would have worsened the situation.
Hence, banks arent in a hurry to cut lending rates. Till this point, the risk factors outweigh
favorable elements for cut in bank lending rates.
We take a look at how the Central Bank rate cut will impact the economy
1. Infrastructure investment to get a push: While announcing the 50 basis points rate cut, RBI
Governor Raghuram Rajan was eyeing a pick-up in investments. He said Investment is likely to
respond more strongly if there is more certainty about the extent of monetary stimulus in the
pipeline, even if transmission is slow. Infrastructure projects have been on a slow track for a
variety of reasons and over the last couple of years there has been a sharp decline in institutional
funding, led both by a decline in demand and banks unwilling to increase their exposure to the
sector. Experts say that a rise in non-performing assets (NPAs) within the sector, high number of
stalled projects and weak financial ability of players led to this decline in loan take-off and
thereby a dip in investments
2. Home loans and corportae loans to be cheaper: Home and corporate loans will cost less after
the apex bank lowered the key interest rate by 0.50 per cent the biggest cut in over three years
to bolster the economy. It will help the conumser both in borrowings and investment. Most of
the banks and housing finance companies will look to bring the rates down in the coming days to
avoid losing customers. With the rate cut, both the new and existing customers will gain.
The new customers will enjoy the benefit of rate cut as the banks will pass on the rate cut benefit
to them anyway. For existing customers, if the bank had initially raised tenure when the rates
were going up, the customer will first see the reduction in tenure and then later when the rates
will go down, there will be a cut in the EMIs. For an existing customer the benefits will not be in
the same proportion as the new customers.
RBI has given a positive surprise to markets, by cutting repo rate by 50 basis points, as against
expectations of 25 basis points cut. Overall, we continue to expect a downward bias in interest
rates in India, which should act as one of the catalysts for investment revival, going hand in hand
with favourable government measures, said Dinesh Thakkar, CMD, Angel Broking.
3. Housing sector will get a boost: The Reserve Bank of India proposed to lower the minimum
risk weight on housing loans from the current 50 per cent. This will enable the banks to free
more funds to lend for affordable housing. With a view to improve affordability of low-cost
housing for economically weaker sections and low income groups and giving a fillip to Housing
for All, while being cognizant of prudential concerns, it is proposed to reduce the risk weights
applicable to lower value but well collateralised individual housing loans, the RBI said. JLL

india Chairman and Country Head Anuj Puri said for the affordable housing sector, the outlook
is nevertheless bright, since the RBI governor has made provisions for lending to this sector to
become less stringent and broader in scope.
4. Realty sector: The realty sector hailed the RBI move to cut interest rate by 0.50 per cent and
developers have asked the banks to pass on the benefits to home loan borrowers that would help
revive housing demand especially during upcoming festive season. Festivals assume a
tremendous significance in India and the occasions which are one of the most preferred days for
buying property for Indian families. This festive season will begin with Navratri soon followed
by Dussehra and Diwali. With the rate cut, we are expecting a change in market sentiments
benefiting the large number of home buyers and various stakeholders of the real estate, Shailesh
Puranik, MD, Puranik Builders said.
5. Auto sector: The rate cut will help auto sector meet 15-20 per cent sales growth in the festive
season as 65 per cent of car sales are financed. A reduction in interest rates will reduce cost of
ownership and help the automakers get more customers. Rajan surprised the market with a
deeper than expected rate cut. This cut comes as a balm for anxious markets and I see the
relieved celebration in the equity and fixed income markets. This pre- Dusshera / Diwali gift will
lift the festive demand as banks will hopefully start reducing the cost of consumer loans. The
industrys expectation of a turnaround in demand led growth in the second half will now be well
anchored, V S Parthasarathy, group CFO, Mahindra & Mahindra Ltd said.

5 sectors that will benefit

. Mortgage: Lower interest rates would directly impact all type of mortgages like housing loan,
car loan, and personal loans, among others. Lower interest rate is expected to push demand in
these segments, which will have a cascading impact on the entire economy. Here the assumption
is that the mortgage has been taken on a floating rate basis. For fixed interest rate mortgages
there is unlikely to be any change.
2. Savings: One of the first rates that banks generally cut when the central bank announces a rate
cut is in deposit rates. Banks do not want to take the risk of raising high-cost funds at a time
when the borrowing rates are falling. Saving rates, be it a savings bank account or fixed deposit
will go down from investors. Money markets which are the first to react will see their interest
rates fall.
3. Economy: In the recent interaction between the government and corporate India it was
pointed out that there are two main reasons why corporate India is not investing in the economy.
First was the ease of doing business and second were high interest rates. Setting up capacity
during a high interest era impacts the cost of the project and viability of the project. Now with
lower interest rates the ball is in the governments court to announce policy changes in order to

prompt corporates to invest.

4. Currency: Interest rate parity is the reason behind balancing of currency rates. Lower interest
rates will not attract capital which is looking for higher yields, which would mean that the
currency would weaken. If the Federal Reserve opts to increase interest rate the differential
between India and the US will reduce further, resulting in further flight of capital.
5. Equity Markets: Equity markets are expected to gain on multiple reasons. First the positive
impact on consumption on account of lower interest rates would mean better topline growth.
Lower interest outgo would also mean high profit and thus better valuations. Further, lower
interest rates means that money will move from lower yielding debt instruments to the equity
market.

Heres how RBIs cut in interest rate impacts your finances

The rate cut means different things to different segments. Existing and potential home loan
customers are delighted because it brings down their borrowing costs. The EMI of a home loan
of Rs 60 lakh for 20 years will come down by almost Rs 1,500. Investors in debt funds and taxfree bonds are also happy because they have made big gains.
Long-term debt funds and taxfree bonds have rallied by nearly 2-4% after the rates were cut.
Corporates are pleased because their cost of capital come .. down and stock investors see this as
a positive development. The Sensex gained more than 500 points in the two days after the rate
cut was announced.
At the same time, investors in fixed income instruments are a worried lot because banks have
brought down their deposit rates. The worst hit are senior citizens who depend largely on the
interest from their fixed deposits and small savings. Our cover story looks at the impact of the
RBI move on the entire spectrum of investors and borrowe ..
Debt fund investors in a sweet spot
Investors who bet on long duration funds have reasons to smile because their investments have
generated good returns. The bond market was anticipating a 25 basis point cut so the RBI move
came as a pleasant surprise. Bond yields crashed, pushing up the NAVs of debt funds that have
lined their portfolios with long-term bonds.
These funds have made solid gains following the 125 bps rate cut by the RBI this year. Will the
rally continue? That depends on whether the RBI will cut rates further. Realistically, one should
not expect any more rate cuts in this financial year. The RBI has very clearly stated that it is
'front-loading' the reduction.

However, if the prevailing disinflationary trend continues, the central bank may cut rates in
2016-17. "The RBI's acknowledgement that the disinflationary trend in prices is here to stay
indicates that further monetary policy easing is likely," says Sahil Kapoor, Chief Market
Strategist, Edelweiss Financial Services. "Taken together with lower than expected inflation for
January 2016 at 5.8% and January 2017 at 4.8% and given the RBI real interest comfort level of
1.5%, there is enough headroom ..
headroom for a further 50 bps cut in 2016-17," says Arun Gopalan, Vice-President - Research,
Systematix Shares & Stocks.
This is why some experts contend that despite the recent rally, this is a good time to enter these
long-term bond funds. The best performing long-term debt funds have delivered up to 17% (see
graphic) in the past one year but they feel there is still a lot of steam left in this category. "There
is no better time to invest in duration funds. Yields will keep inchin ..
southward for some time," says Sujoy Das, Head of Fixed Income, Religare Invesco Mutual
Fund.
"Investors can expect yields to soften by another 20-30 bps, after which they could perhaps look
at switching from a duration play to an accrual strategy," said Lakshmi Iyer, Head, Fixed Income
& Products, Kotak Mutual Fund. Others argue that putting fresh money into duration funds may
not be a wise idea.
http://economictimes.indiatimes.com/wealth/savingscentre/analysis/heres-how-rbis-cut-in-interest-rate-impacts-yourfinances/articleshow/49203251.cms

When we talk about interest rates in general, we are referring to the rate at which other
banks can borrow overnight from the central bank to fulfill their reserve requirements. It is
through this rate that the RBI can influence all sorts of interest rates in India. A reduction in
interest rates will have the following effects.
1. Effect on corporations: A drop in the interest rates will bring down the cost of capital,
companies will borrow more to produce more, they will hire more workers reducing
unemployment and increasing wage rates. This coupled with the reforms the NDA
government is trying to bring in will increase industrial output and hence GDP.
2. Effect on consumers: This will also increase consumer spending and hence
consumption. Increased consumption will add to aggregate demand which in due course
of time will reflect in India's GDP. Household savings will reduce because the interest
rate is less and hence there is no incentive to save and loans will go up because there is
no downside to borrowing. The increased borrowing will boost up the real estate market
as people will increasingly take advantage of the low interest rate to take home loans just
like Mr. Wolf below:
3. Conclusion: The Economy as a whole will be better off in theory. None of
these benefits will happen in isolation all of them have a disturbing catch

attached to them and why shouldn't there be, we live in a Pareto optimal
world don't we? Let's look at the disadvantages of such a reduction.
4.

5. What are the disadvantages of interest rate reduction?

6.
All of the aforementioned benefits of reducing interest rates have one caveat,
they increase inflation. Reduced unemployment is directly correlated with
inflation through the Phillips curve. A decrease in unemployment will increase
inflation correspondingly. Increased consumer spending will increase price
level of goods thereby increasing retail inflation. Everything will become
expensive*. Inflation is something that has destroyed economies in the past
if not controlled. Conclusion: The biggest disadvantage is rising inflation.
Rates should be reduced only if we feel we can handle the inflation.

Government v/s the RBI **

The present not so hidden tussle between the government and the RBI is one of
conflict of interest. The NDA government has come to power with a promise to
revive the economy. They want to show a quick revival but reforms and fiscal policy
tools are slow in implementation. The only policy tool fast enough to show recovery
at least on paper is monetary policy which is controlled by Mr. Rajan.
Mr. Rajan is a very smart central banker***. He knows exactly what the
government's intentions are. He knows that India is a very fragile economy
vulnerable to global price shocks. When he took up this job, inflation was pushing
India towards a recession. He tamed it with stern monetary policy. To lower interest
rates now has a strong chance of pushing inflation to its pre-2012 levels which will
revert Mr. Rajan's efforts to protect Indian economy.
Inflation itself is a mysterious economic process for a high inflation and a low
inflation are equally disastrous, a high inflation can easily can easily turn into
stagflation while a low level of inflation can easily turn into deflation [1]. Mr. Rajan's
first priority right now it to bring inflation down to its optimal level, a level that is
sustainable and corresponds to the natural rate of unemployment ****. He will
reduce interest rates once he is satisfied that the country's economy is safe. The
government's attitude on the other hand is one of, 'let's be a little lax now, show the
country our awesome performance, and if Inflation comes back to haunt us, we
always have Dr. Rajan to save us while we will blame it on the global economy'.
onclusion: I have always maintained that Dr. Rajan is one of the best
macroeconomists of our age. When it comes to opinions on reviving Indian economy
so that it is stronger in the long run, his opinion carries the most weight.
Stagflation

In economics, stagflation, a portmanteau of stagnation and inflation, is a situation

in which the inflation rate is high, the economic growth rate slows, and
unemployment remains steadily high. It raises a dilemma for economic policy, since
actions designed to lower inflation may exacerbate unemployment, and vice versa.
Stagflation is very costly and difficult to eradicate once it starts, both in social terms
and in budget deficits.

Economists offer two principal explanations for why stagflation occurs. First, stagflation can
result when the productive capacity of an economy is reduced by an unfavorable supply shock
that causes an increase in the price of oil for an oil-importing country. Such an unfavorable
supply shock tends to raise prices at the same time that it slows the economy by making
production more costly and less profitable.[7][8][9] Milton Friedman famously described this
situation as "too much money chasing too few goods".
Second, both stagnation and inflation can result from inappropriate macroeconomic policies. For
example, central banks can cause inflation by permitting excessive growth of the money supply,
[10]
and the government can cause stagnation by excessive regulation of goods markets and labour
markets.[11] Excessive growth of the money supply, taken to such an extreme that it must be
reversed abruptly, can be a cause. Both types of explanations are offered in analyses of the global
stagflation of the 1970s: it began with a huge rise in oil prices, but then continued as central
banks used excessively stimulative monetary policy to counteract the resulting recession, causing
a runaway price/wage spiral
Deflation

In economics, deflation is a decrease in the general price level of goods and services.[1] Deflation
occurs when the inflation rate falls below 0% (a negative inflation rate). This should not be
confused with disinflation, a slow-down in the inflation rate (i.e., when inflation declines to
lower levels).[2] Inflation reduces the real value of money over time; conversely, deflation
increases the real value of money the currency of a national or regional economy. This allows
one to buy more goods with the same amount of money over time.
Economists generally believe that deflation is a problem in a modern economy because it
increases the real value of debt, and may aggravate recessions and lead to a deflationary spiral.[3]
In the IS/LM model (Investment and Saving equilibrium/ Liquidity Preference and Money
Supply equilibrium model), deflation is caused by a shift in the supply and demand curve for
goods and services, particularly a fall in the aggregate level of demand. That is, there is a fall in
how much the whole economy is willing to buy, and the going price for goods. Because the price
of goods is falling, consumers have an incentive to delay purchases and consumption until prices
fall further, which in turn reduces overall economic activity. Since this idles the productive
capacity, investment also falls, leading to further reductions in aggregate demand. This is the

deflationary spiral. An answer to falling aggregate demand is stimulus, either from the central
bank, by expanding the money supply, or by the fiscal authority to increase demand, and to
borrow at interest rates which are below those available to private entities.
In more recent economic thinking, deflation is related to risk: where the risk-adjusted return on
assets drops to negative, investors and buyers will hoard currency rather than invest it, even in
the most solid of securities.[4] This can produce a liquidity trap or it may lead to shortages that
entice investments yielding more jobs and commodity production. A central bank cannot,
normally, charge negative interest for money, and even charging zero interest often produces less
stimulative effect than slightly higher rates of interest. In a closed economy, this is because
charging zero interest also means having zero return on government securities, or even negative
return on short maturities. In an open economy it creates a carry trade, and devalues the currency.
A devalued currency produces higher prices for imports without necessarily stimulating exports
to a like degree.
In monetarist theory, deflation must be associated with either a reduction in the money supply, a
reduction in the velocity of money or an increase in the number of transactions. But any of these
may occur separately without deflation. It may be attributed to a dramatic contraction of the
money supply, or to adherence to a gold standard or other external monetary base requirement.
However, deflation is the natural condition of hard currency economies when the supply of
money does not grow as quickly as population and the economy. When this happens, the
available amount of hard currency per person falls, in effect making money more scarce, and
consequently, the purchasing power of each unit of currency increases. Deflation occurs when
improvements in production efficiency lower the overall price of goods. Competition in the
marketplace often prompts those producers to apply at least some portion of these cost savings
into reducing the asking price for their goods. When this happens, consumers pay less for those
goods, and consequently deflation has occurred, since purchasing power has increased.

To be or not to be conservative?
In short, he (Mr. Rajan) is not conservative ideologically. He belongs to the
Chicago school of economics, a school of thought that pioneered the concept of the
free market. When he was appointed as the governor of the Reserve Bank of India, a
Businessweek headline ran, ' Mr. Free Market, Raghuram Rajan goes to India' [5].

His statements while in his current position are a constant reminder that India needs
change, not conservatism. He once said that inefficient management especially of
PSU's should be changed because such managements destroyed Japan. This is
definitely not conservatism Indian industry expects from an RBI governor who has
bureaucratic baggage.
In India, conservatism is listening to rate cut lobbyists and delay financial reforms.
Mr. Rajan has done neither and he won't in the near future, he is an economist from
the same institution that gave us Milton Friedman, not a lowly bureaucrat
appointee. He is not conservative, any such perception is a figment of your
imagination.
But why is he acting conservatively despite his free market background?
For an answer to this question, you have to look no further than the state of Indian
economy when he took over. John Maynard Keynes once said, "When facts change, I
change my conclusions, What do you do Sir?" in response to being criticized for
advising against his own policies once. Dr. Rajan did the same thing. When Dr. Rajan
assumed office, Indian economy needed an inflation warrior, he became one and
has remained so against the wishes of this government.

What does a cut in interest rates mean for the stock market?

When the next Federal Reserve meeting is expected to bring interest rate cuts or increases, it is
wise, as a stock investor, to be aware of the potential effects behind such decisions. Although the
relationship between interest rates and the stock market is fairly indirect, the two tend to move in
opposite directions. Here's why.
A decrease in interest rates means that those people who want to borrow money enjoy an interest
rate cut. But this also means that those who are lending money, or buying securities such as
bonds, have a decreased opportunity to make income from interest. If we assume investors are
rational, a decrease in interest rates will prompt investors to move money away from the bond
market to the equity market. At the same time, businesses will enjoy the ability to finance
expansion at a cheaper rate, thereby increasing their future earnings potential, which, in turn,
leads to higher stock prices. Investors and economists alike view lower interest rates as catalysts
for expansion.
Overall, the unifying effect of an interest rate cut is the psychological effect it has on investors
and consumers; they see it as a benefit to personal and corporate borrowing, which in turn leads
to greater profits and an expanding economy.

Marginal Propensity to Save

The marginal propensity to save (MPS) is the portion of each extra dollar of a households
income used for saving. This can be calculated by dividing changes in saving by changes in
income. The marginal propensity to save plays a starring role in Keynesian economics,
quantifying the saving-income relation, which is the flip side of the coin to the consumptionincome relation. The MPS indicates what the overall household sector does with extra income.
Specifically, it indicates the percent of extra income that is saved by households. As saving is a
complement of consumption, the MPS reflects key aspects about a households activity and its
consumption habits.
Such activity is central to the study of macroeconomics. It is also vital to the study of Keynesian
economic theory. The MPS captures induced saving, which is one aspect of the psychological
law of spending performed by consumers. The MPS reflects the saving line's slope, which is the
foundation on which the Keynesian injections-leakages model is based. The MPS acts as a
multiplier, affecting the magnitude of both expenditures and the tax multipliers. For example, if
the marginal propensity to save is 45%, out of each additional dollar earned, 45 cents is saved.

Marginal Propensity to Consume

The marginal propensity to consume (MPC) is the portion of each extra dollar of a households
income used in extra expenditures. This is calculated by dividing changes in consumption by
changes in income. The MPC plays a key role in Keynesian economics in that it quantifies the
consumption-income relation. The MPC indicates the portion of a households additional income
that is used for consumption and expenditures.
The MPC is also vital to the study of Keynesian economics. It captures induced consumption and
the psychological law of consumer spending. The MPC reflects the consumption line's slope,
making it the foundation for the slope of the aggregate expenditures line. The MPC, like the
MPS, affects the multiplier process and affects the magnitude of expenditures and tax
multipliers. For example, if the marginal propensity to consume is 45%, out of each additional
dollar earned, 45 cents is spent.
Ultimately, both MPS and MPC are used to discuss the ways in which any entity utilizes its
surplus income, whether that income is saved or spent. Consumer behavior in regard to saving or
spending has a very significant impact on the economy as a whole.

What happens if interest rates increase too quickly?

When interest rates increase too quickly, it can cause a chain reaction that affects the domestic
economy as well as the global economy. It can create a recession in some cases. If this happens,

the government can backtrack the increase, but it can take some time for the economy to recover
from the dip.

Understanding Interest Rates

Adjusting interest rates is one way that a central bank can encourage employment and keep
prices stable in an economy. Interest rates have an impact on everything from home mortgage
prices to the ability of a business to expand through financing. If interest rates go too high or are
pushed higher than what people and companies can readily afford, spending could stop. In this
sense, higher interest rates could mean that a person may not be able to get a loan to purchase a
house on favorable terms, or that a company will lay workers off instead of financing payroll
during a downturn.

Looking for Balance

Raising interest rates can slow down the economy, bringing inflation with it, while lowering
interest rates can encourage spending. Lowering interest rates is a powerful form of economic
stimulus, but it cannot be overdone. The goal is to keep inflation around 2% per year for personal
consumption expenditures, but it requires a careful balance.

When Interest Rates Go Up

When the U.S. Federal Reserve raises the federal funds rate, the cost of borrowing goes up too,
and this increase starts a series of cascading effects. In essence, banks raise their interest rates for
consumers and businesses, and it costs more to buy a home or finance a company. In turn, the
economy slows down as people spend less. However, this also keeps the cost of goods stable and
curtails inflation. It serves as a signal that economic growth in the United States is expected to be
firm as well.

Timing Is Everything
It all comes down to timing. The economy has to be robust enough to handle the increase in the
cost of borrowing. If the Fed increases interest rates too quickly before the economy is ready
for it the realized effect of the interest rate increase can be too much, and the measure could
backfire. The economy would become strained and fall into a recession. Moreover, the effect of
interest rates going up would not be felt only in the U.S. If interest rates rise too quickly, the
comparative value of the dollar could go up, affecting world markets as well as domestic
companies with businesses in other countries.

How can the federal reserve increase aggregate demand?

The Federal Reserve can increase aggregate demand in indirect ways by lowering interest rates.
Aggregate demand is a measure of the total consumption of goods and services over any time

period. Aggregate demand is the most important ingredient that can be targeted by the
government through fiscal or monetary policy.

Fiscal Vs. Monetary Policy

Fiscal policy is a much more direct way to affect aggregate demand as it can put money directly
in the hands of consumers, especially those who have the greatest marginal propensity to spend.
This increased spending leads to positive spillover effects such as businesses hiring more
workers.
Some typical ways fiscal policy is used to increase aggregate demand include tax cuts, military
spending, job programs and government rebates. In contrast, monetary policy uses interest rates
as its mechanism to reach its goals. Ostensibly, the Federal Reserve's mandate is to balance
competing goals of employment and price levels.

Targeting Aggregate Demand

However, aggregate demand is an important component in both of these measures. Therefore, the
Federal Reserve is deeply concerned with it. When resources are constrained and there is an
increase in aggregate demand, inflationary risks increase. If total consumption of goods and
services in the economy decreases, then businesses have to let go of workers in response to the
declining revenue.
The Federal Reserve's direct effect on aggregate demand is mild. When it lowers interest rates,
asset prices climb. Higher asset prices for assets such as homes and stocks boost confidence
among consumers, leading to purchases of larger items and greater overall spending levels.
Higher stock prices lead to companies being able to raise more money at cheaper rates.

Adverse Effects
Bond markets, stock markets and commodities hit all-time highs within five years of the bottom
in asset prices of March 2009. Economic conditions slowly improved, but many people were left
out of the recovery. This divergence highlights the limitations of monetary policy in such
circumstances.
Gridlock in Congress led to a complete halt in any sort of discussion of fiscal policy. The Federal
Reserve started buying billions of dollars worth of bonds to improve liquidity and financial
conditions. Given the lackluster recovery, it failed to generate aggregate demand.
Critics of the Federal Reserve highlight this as evidence its policies are ineffective in helping the
middle class. Additionally, they say the fruits of easy financial conditions flow to those who own
assets. Easy financial conditions lead to asset bubbles, which can create wasteful investment,
wealth destruction and harm to the economy.

Defenders of monetary policy argue that without monetary policy, the economy would be much
worse. However, it is difficult to quantity. One comparison is the relative outperformance of the
United States versus Europe or Japan. The Federal Reserve was much more aggressive than these
central banks, and it resulted in higher growth rates.

How does the stock market react to changes in the Federal Funds Rate?

The stock market reacts to changes in the federal funds rate in various ways depending on where
it is in the business cycle. In a vacuum, cuts in the federal funds rate are bullish for the stock
market, while increases in the federal funds rate are bearish for stocks. In reality, the situation is
more complicated as adjustments in the federal funds rate tend to offset an overheating or
slumping economy.

Decreases in the Federal Funds Rate

When the economy is slowing, the Federal Reserve cuts the federal funds rate to stimulate
financial activity. At certain times in the business cycle, the modest boost provided by lower
rates is not enough to offset the loss of economic activity due to a weakening economy. In this
environment, stock prices continue to decline. However at some point, the stock market finds its
footing once the economy begins to bounce back.
Within the stock market, some winners of lower federal funds rates are dividend-paying sectors
such as utilities and real estate investment trusts (REITs). Additionally, large companies with
stable cash flows and strong balance sheets benefit due to a lower cost of borrowing.

Increases in the Federal Funds Rate

Normally, higher federal funds rates lead to weakness in the stock market due to capital
becoming more expensive. However, the Federal Reserve typically only raises this rate when
growth is strong. Therefore, at early stages in the business cycle, the higher rates do not deter the
stock market as economic activity keeps increasing.
However some sectors disproportionately benefit such as banks, brokerages and insurance
companies. These companies' earnings increase as interest rates move higher, while rate-sensitive
stocks suffer outflows.

How the Fed Fund Rate Hikes Affect Your Stock Portfolio

As of 2015, the Federal Reserve has maintained an interest rate policy that has kept the federal
funds rate near zero for over six years. These low interest rates, coupled with multiple rounds of

quantitative easing, have helped pull the economy out of the last recession. This successful
strategy has been used as guidance for other recessions in the eurozone and Japan.
However, the United States has never had a zero-rate policy for this long and has never
implemented a quantitative easing program prior to 2009. As a result of these new strategies,
there have been many unintended consequences in the capital markets. Now that the Federal
Reserve intends to increase the federal reserve rate, it is important to understand what
consequences and effects the change in policy will have on stock portfolios.

Fed Fund Rate Hike's Effect on Equities

The unprecedented monetary and fiscal policies over the past six years have had large effects on
the U.S. equity market. Domestic equities have tripled since their March 2009 lows. Corporate
earnings doubled over the past six years, from $417 billion to $1.04 trillion. Total capitalization
of the S&P 500 Index grew from $6 trillion in 2009 to $19 trillion in 2015.
These sharp increases in equities, corporate earnings and capitalization are due in large part to
the low interest rates and quantitative easing (QE), which forced capital into financial assets,
pushing stock prices up and pushing yields on fixed-income instruments lower. From here, some
expect an increase in interest rates by the Federal Reserve will be bad for the equity markets.
However, this might not be true. There have been six rate increases since May of 1983, and the
average return of the S&P 500 Index after the initial hike was 14.4%. Past performance shows
that an increase in the federal funds rate does not have much of a negative effect on people's
stock portfolios.
Even though the U.S. economy is in the middle of a correction, the earnings yield on the S&P
500 is 5.5% based on 2015 earnings estimates, which is almost exactly where it was in March
2009. This indicates that equity valuations have not become overvalued with low interest rates
and should continue to perform well even with an increase in the federal funds rate.
Dividends and share repurchases were roughly $900 billion in 2014 and are estimated to reach
$1 trillion in 2015. The 10-year Treasury yield is close to 2.2%, and the yield on cash is close to
0%, both of which compare favorably with the current earnings yield on the S&P 500. These are
all signs that equities should continue to perform well in any investor's stock portfolio, even with
an increase in interest rates.

Fed Fund Rate Hike's Effect on Alternative Investments

The performance of alternative investments will have an effect on an investor's stock portfolio if
that portfolio contains hedge funds and equity index funds. During quantitative easing, hedge
fund returns were disappointing when compared to the performance of equities. With the U.S.
serving as the risk market of choice for investors during QE, a large amount of risk-on money

flowed into equity index funds. This made stock picking for equity index funds very difficult and
hurt overall performance.
However, performance turned around for both hedge funds and equity index funds in January
2015. As of the middle of 2015, the HFN Fund Aggregate Index, a representation of alternative
investments, was up 3.23% and the HFN Equity Hedge Index was up 5.12%.
This compares to a performance of 2.6% percent for the S&P 500 Total Return Index over the
same period. While it is hard to predict whether trends like these will continue with federal funds
increases, it shows that alternative investments perform well enough to be part of an investor's
stock portfolio.