0.5% rate cut by BOE, ECB - Views on News from Equitymaster

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0.5% rate cut by BOE, ECB

Nov 9, 2001

Both the Bank of England and the European Central Bank have slashed rates interest rates by 0.5%. The move follows the deterioration in economic fundamentals and the rate cut in the US. Lower interest rates, though by no means the only, are a critical part of any plan designed to fight of a global recession. Lower interest rates benefit the economy in several ways. Lower cost of money is an added incentive for corporates to invest and for consumers to make purchases i.e. the demand for consumption and investment goods tends to increase.

Let's take the example of purchasing a house. In India itself, the persistent decline in interest rates has made home ownership much more affordable. Indeed, demand for loans to fund home purchases continues to grow robustly. Same is the case in the US, where housing continues to record a relatively better performance as compared to the other sections of the economy. The demand for homes leads to more construction activity thus resulting in derived demand for cement, steel and a whole host of other commodities. Not to forget, it also generates employment, resulting an increase in overall economic activity.

The persistence of central banks to cut interest rates to stimulate demand seems to have had little effect on the slowing global economy. But then this is to be expected given that the monetary policy can take anywhere from six months to twelve months to impact the real economy, as the lower interest rates take time to percolate into the economy.

There is increasing pressure on countries to step up government spending, which is likely to have an immediate impact on demand. For example in India, to ward off the slowdown, the Government has embarked on a massive road construction program. The US too has undertaken several measures to stimulate demand. However, as is evident from the numbers, there is little respite from a slowing global economy.

In such a bleak global scenario, it is natural for investors to shun the stock markets and invest in relatively safer fixed income securities. However, even in this environment, stocks should find a prominent place in an investor's portfolio. Why do we say that?

Stock market valuations have come off dramatically from the heady days of February 2000. While a large part of the 'deflation' in valuations was justified, the markets surely seem to have gone overboard in some cases. The fallout of the September 11 attacks has only resulted in a number of these stocks becoming more attractively valued. Picking up such stocks surely presents an opportunity to buy good companies at attractive valuations.

Ofcourse, there will probably be near term hiccups. But then long-term investors need to ignore these disturbances. Ultimately what matters to them is how much money has been made over a, let's say, three-year horizon, on a point-to-point basis.

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