The interest rate is fixed periodically by the central banks of each country, in case of Indian which is Reserve Bank of India . This rate of interest is then implemented by all the state owned banks as well as the private banks that are operating in India . The central bank modifies the rate of interest from time to time to keep a check on flow of money in the market so as to control the inflation. This has an underlying effect on economy of the country and on the stock markets as well. But before we get into the discussion on how the interest rate controls the stock market, let us take a look why the central banks change the interest rate.
Why central bank raises and reduces the rate of interest?
The central banks keeps a close eye on the whole price index, retail market and money market of the country and revises the interest rates periodically, mainly to keep check on the flow of money in the market and control inflation in the country. When the interest rate is low there is more supply of money in the market/a> that spurs the growth of the economy and also raises the inflation rate. In this scenario when the central bank wants to control the flow of money in the market and check the rate of inflation, they raise the rate of interest that reduce flow of money in the market and control the inflation.
Impact of interest rate on stock market
Among all other factors that control price of stocks and movement of stock market, rate of interest is a crucial factor that directly and indirectly affects the stock market in many ways. It is often seen that when the rate of interest is raised there is a negative effect on the stock market. On the other hand the rate of interest is reduced the stock market moves higher. There are some underlying factors that cause this effect of interest rate on the market.
Growth of industry – When the rate of interest is brought down by the central bank that means companies can get more money at lower cost. With lower rate of interest money becomes inexpensive for the businesses. They can get loans and finance for further expansion or to boost their working capital. This is a positive sigh not only for that business but also for the overall economy of the country as with enhanced production, the GDP and other indicators also move positively. As the commerce and industry show a positive movement and there is growth of the economic factors, the stock market also sees a surge in investment. Domestic as well as foreign investors start investing in the market increase the demand of the stocks and eventually take the market up.
Buying powers – When the rate of interest is reduced there is more money in the market. With lower rate of interest there is a lack of savings as well as easy availability of finance in the money market. This trend significantly increases the buying capacity of the consumers and multiplies the flow of money in the market. This is good for the industries as there is demand for their product in the market while it creates more jobs as well. So with lower rate of interest the economic factors like buying capacity, wholesale price index, retail price index and other indicators also take a positive turn which makes a positive impact to the stock market.
Investors’ psychology – When the rate of interest is raised by the central bank most of the investors in the stock market, especially the scalp traders, prefer to withdraw their investment from the market and put that money to banks and other form of savings where they can earn higher interest. This is a common psychology amongst the investors that when rate of interest is raised the stock market is going to fall and that is the reason they sell their holding stocks to recover their profit and put the money is safer investment options. This trend surely lowers the demand of stocks at the stock market and has a negative effect on the stock market.
These are the primary factors that directly influence that growth of the industry and business as well as control the demand for stocks at the stock market. As these are the factors that control the ups and downs in the price of the stocks, so it is quite evident that the rate of interest has also a part to play in stock prices.