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In the bi-monthly monetary policy review held on 5-Aug-2019, RBI reduced policy repo rate by 35 bps to 5.4%. The decision was based on the inflation expectations which has been lower than the median target of 4%. The growth projections have fallen from the one given in Jun-19 policy. The decision to cut policy rates was unanimous amidst the 6 members.

RBI Policy Inflation Expectations
(2019-20, in %)
GDP Expectations
(2019-20, in %)
H1 H2 H1 H2
Apr-19 2.9 – 3 3.5-3.8 6.8-7.1 7.3-7.4
Jun-19 3-3.1 3.4-3.7 6.4-6.7 7.2-7.5
Aug-19 3.1
(Q2 2019-20)
3.5-3.7 5.8-6.6 7.3- 7.5

 

However, markets were surprised by not the cut in interest rates which was widely expected, but the magnitude of the measure. Usually, central banks cut policy rates in multiples of 25 bps but this one was a change of 35 bps. In April-2019, RBI Governor Mr. Shaktikanta Das in a speech had questioned the status quo of changing policy rates in multiple of 25 bps, saying it is just a convention and is not sacrosanct.  He further added that if a central banker wanted to ease with caution, a 10 basis points reduction would signal the intent without a need for 25 bps reduction which could be too large given the situation. Similarly, in an opposite situation where the central bank wishes to ease policy but thinks that 25 bps is little whereas 50 bps is too much, a reduction of 35 basis points would convey the message.

This point was also raised by MPC member Prof Ravindra Dholakia in Feb-19 and Apr-19 policy meetings. In Feb-19 meeting, he said there is space for rate cuts in the range of 50 to 60 bps and in Apr-19 he spoke about his preference for a rate cut in the range of 35 to 40 bps.

The RBI MPC this time did act on both Governor and MPC member and agreed to cut repo rate by 35 bps. The vote was not unanimous though, with 4 members voting to cut by 35 bps whereas 2 members preferring the conventional 25 bps. My research suggests that thus was the first time when RBI changed its policy rate by magnitude other than 25 bps but Bank of England has changed rates in denominations other than 25 bps. In a tweet, SBI chief economist SK Ghosh pointed to the evidence from China where policy rate has been changed in multiple denominations.

The bigger question though is the impact of rate reductions. The pass through of changes in policy interest rates to bank interest rates also known as monetary transmission, has been a matter of contention for a long time now.

RBI Governor in the media interaction pointed that RBI rate cuts of 75 bps in Feb-Jun 19 period, has led to decline in weighted call money rate (WACR) by 78 bps, market repo rate by 73 bps and 10-year benchmark G-sec yield by 102 bps. Thus, transmission has been complete in overnight interest rate markets (call and repo) which is expected as it tracks the RBI repo rate really closely. The transmission has been much higher in G-sec market where yields have eased due to government keeping fiscal deficit as per target. The announcement of issuing overseas bond has also played a role in the decline of yields.

However, the key is whether banks have reduced their interest rates. RBI Governor said that banks have lower interest rates by 29 bps on fresh rupee loans. This is the crux of the problem as banks are unable to pass lower interest rates due to cost of liabilities which still remain high. There are constant complaints from borrowers that there have been no or marginal reduction in old loans. Whereas interest rates rates on deposits have fallen. Thus, people are suffering on both fronts, lower earnings and stubborn interest rate costs.

RBI Governor added that he has been talking actively with bankers to pass the interest rate reductions to borrowers. The RBI expects banks to transmit higher interest rate reductions in near future. We have to wait and see whether banks meet RBI expectations.

 

 

 

 

By Amol Agrawal

Faculty member, Ahmedabad University