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Let’s Not Go Gaga Over The Rate Cut

 R K PATTNAIK & JAGDISH RATTANANI

THE rate cut last week by the monetary policy committee is unparalleled in the monetary policy history of the Reserve Bank of India since it is for the first time that the policy repo rate has been cut for the third time in a row in a calendar year. Headlines tend to translate a policy repo cut to a lower EMI for housing and car loans as if this translation and transmission is direct, immediate and necessarily achieved. The reality is far from that. What the MPC cuts is the policy repo rate, which is the rate at which banks can borrow overnight from the RBI to meet their regulatory requirements and resolve mismatches in their portfolios. This is like pulling a rather long string at one end. This pull is then calibrated if not mitigated by a series of players along the line, who will pull in various directions such that when the disturbance (the rate action) reaches the other end, it may have been absorbed by the system and is not always seen by the end consumer.  The question that should be asked therefore is: will the cut translate this time to an EMI cut.

The MPC comprises six members, including the RBI Governor, one Deputy Governors, one RBI officer nominated by the central bank (the executive director this time) and three outside experts. They are legislatively mandated to “maintain price stability keeping in mind growth”, and specifically, keep inflation in the region of 4 per cent, with a band of two percentage points up or down.

We have seen a continual decline in the official inflation rate. The CPI headline inflation rate has been lower than the legislatively mandated average rate of 4 per cent since August 2018. The outlook on inflation as per the RBI forecast remains benign and also below the mandated rate in 2019-20. There is also a sharp decline in the core inflation (i.e. headline CPI inflation excluding food and fuel inflation) to 4.5 per cent in April 2019 from 5.1 per cent in March 2019 and around 5.5 per cent in February 2019. Even the inflation expectation of households in May 2019 as evident from the RBI survey has declined by 20 basis points in a three-month ‘ahead horizon’.  Growth, on the other hand, is down – a sub-par 7 per cent growth. The MPC has assumed a growth rate of 7 per cent for 2019-20, with risks evenly balanced.

Now the expectation of the MPC is that given the benign inflation outlook, the   policy repo rate cut by 75 basis points in the 2018 calendar year so far (three cuts of 25 basis points each) will have a cumulative effect on the reduction of bank lending rates. The reduction in the banking lending rate will have two implications: (a) boosting investment in the economy and (b) encouragement of private consumption in consumer durables, housing etc.

How will the above process work? The policy repo rate is an overnight rate through which RBI injects liquidity in the economy by lending to the banks. Once the RBI cuts this rate, a chain reaction does start in three markets viz; (a) money market, (b) bond market and (c) credit market. The money market provides the funds to the banks from overnight to one year and is guided by the overnight weighted average call rate. 

As the RBI overnight lending rate is reduced, the money market rates also get reduced. Given the reduction in interest rate in the short end of the market, the debt market rates which are longer term rates, get reduced. The credit market rates, particularly the longer term rates, charged by the banks also gets reduced and the bank charges lower rates for investment and consumption.

The above chain reaction is popularly known by the economists and explained in the textbooks as demand management policy intervention by the central bank and government. But there are operational challenges in terms of impediments to the effective transmission of monetary policy action. These impediments include (a) lack of  full integration of money, debt and credit market, (b) persistence of high revenue deficit and fiscal deficit of the government resulting in higher borrowings from the market thereby putting pressure on the longer term interest rate, (c) higher interest rate in small savings and provident funds thereby resulting in disintermediation from the bank deposits, and (d) weak global demand for our exports coupled with uncertainty in oil prices resulting in a higher current account deficit. The last leads to a depreciation of the rupee and eventually has an impact on the interest rate.

As evidence suggests, the banks are hesitant to accommodate the rate reduction by the RBI as there are rigidities in terms of the asset-liabilities mismatch as far as interest rates go. Given the alternate source of saving instruments like small savings, mutual funds, provident funds with tax benefits, the banks find it difficult to reduce the deposit rates. Keeping the status quo in the deposit rates, any reduction in lending rates negatively impacts the net interest income of the banks. Above all persistence of NPAs at very high levels makes bank lending difficult.

To sum up, we need to be cautious about headlines that offer a direct linkage between reduction in policy repo rates and bank lending rates. This is often not the case in a big machine that has creaky parts and does not always move smoothly.

The Billion Press

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