On Federal Reserve’s track

Love it or hate it; but you cannot ignore it. That is the Federal Reserve for you. Words like taper, QE, Fed are peppering most stock market conversation these days and are also the perpetrators of huge doses of volatility in recent times. Here is a brief introduction to “The Fed” and how it moves the Sensex and Nifty.

The Federal Reserve or ‘The Fed’ is the central bank of United States, much like the Reserve Bank of India (RBI) tasked to control interest rates, money supply, oversee the banking system, control inflation and so on.

The Federal Open Market Commission (FOMC) is the committee of the Fed that meets around eight times in a year to take monetary decisions on — reserve requirement (how much a bank to hold in reserves), discount rate (the interest rate charged by the Fed to commercial banks and other depository institutions on loans they receive from the Federal Reserve Bank’s lending facility), open market operations (used by the Fed to purchase US government bonds in the open market as a means to adjust the Federal Funds Rate, which in turn controls the inter-banking lending rates) and other decisions.

Most of these have lost relevance post-2009 when Quantitative Easing came into play.

Quantitative Easing (QE): Usually central banks try to increase lending activity indirectly by cutting interest rates. Lower interest rates encourage people to spend and not save which, in turn, boosts the economy. But when the rates were already close to zero by 2009 and could go no lower, the Fed decided to print and start pumping money into the economy directly, which can also be called QE.

How this works is: The FED prints money and uses this money and its reserves to purchase government bonds from private sector companies or institutions such as insurance companies, pension funds and banks. With the increased demand for US government bonds, the value goes up thereby making them more expensive to buy and a less attractive investment.

The companies and institutions who sold the bonds then use the proceeds to invest in other companies or lending rather than buying more bonds.

With so many more companies and institutions having money to lend, the interest rates stay low, so more money is spent thus boosting the economy.

Tapering of QE (Taper): Presently as part of QE, the Fed is purchasing $85 billion in government debt and mortgage-based securities every month but the FED Chairman Ben Bernanke has previously indicated that they might start scaling back on these monthly purchases (tapering of QE) which has caused stress in the financial markets as investors fear lesser money in the financial system (liquidity).

How do the Sensex, Nifty and the rupee get affected by all of this: In the recently conducted FOMC meet, the broader consensus was that since the Fed Chairman had indicated tapering of QE, the monthly stimulus of $85 billion would be cut by $10 to $15 billion.

As that was not to be, the markets rallied by over 3 per cent the day after the meeting.

Foreign institutional investors with easy access to capital are expected to extend their buying spree in Indian stocks which might also help the rupee appreciate further.

Appreciated rupee would help reduce the current account deficit by lowering our cost of imports on crude, gold and others.

This would, in turn, help the RBI to start taking steps toward unwinding liquidity tightening measures.

(The author is Director, Zerodha and heads trading and risk management.)

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