Interest rate : Significance

Movement in interest rates affect banks, corporate world and 'WE, THE PEOPLE'. Several factors like stock markets, foreign exchange rate, foreign investment (direct and indirect) also influence and are influenced by interest rate. Interest rates are determined by the markets, but the central's bank monetary policy also affects short-term interest rate.

Which interest rate are we talking about ? Financial market has two type of interest rates. The first type is for treasury operations, including money market and G-sec(Government Securities) rate. We can refer it as Debt/Money Market interest rate. The second type is the interest rates offered by banks for their products. This can be called as 'product rate'. Debt/MM rate becomes benchmark for several other rates. Product rate depends on factors like bank's sources of funds, deposits, internal costing methods, Non Performing Assets, loan profile etc.

Banks generally prefer a rising interest rate scenario, since they are suppose to lend to people more than they borrow by issuing bonds. This way, they can improve their yield on Net Interest Margins. For corporates, interest rates forecast help in taking important decisions like choosing debt or equity instruments to raise funds and at fixed or floating interest rates. Public can think of going for short-term or long term deposits at different types of interest rate.

If RBI adds money into the economy, the demand for bonds increases to maintain the money market equilibrium. The price of bonds increase, hence yields over a period decrease which leads to the decrease in interest rate (here Debt/MM rate). But, it is not necessary that banks follow suit with the Prime Lending Rates(PLR) and deposit rates. They may reduce product rate but it may not be in similar proportion as DM rate. The deposit rates of the banks have to compete not only with other banks (which may have different product rates) but also with the Small Savings Scheme offered by the Government.