In its monetary policy review Wednesday, the Monetary Policy Committee of the RBI decided to cut the repo rate by 35 basis points (bps). Repo rate is the rate at which the RBI lends money to commercial banks. 100 bps make a full percentage point. The RBI’s repo rate has now fallen 110 basis points since February. The RBI also announced some measures to boost economic activity.
Why does monetary policy matter?
In any economy, economic activity, which is measured by gross domestic product or GDP, happens by one of four ways. One, private individuals and households spend money on consumption. Two, the government spends on its agenda. Three, private sector businesses “invest” in their productive capacity. And four, the net exports — which is the difference between what all of them spend on imports as against what they earn from exports. At the heart of any spending decision taken by any of these entities lies the question: What is the cost of money?
Monetary policy essentially answers that question. In every country, the central bank is mandated to decide the cost of money, which is more commonly known as the “interest rate” in the economy. While various factors make it difficult for a central bank to exactly dictate interest rates, as a thumb rule, RBI’s decision on the repo rate sets the markers for the rest of the economy. In other words, the EMI for your car or home is determined by what the RBI decides.
What is the repo rate?
Repo and Reverse repo are short for repurchase agreements between the RBI and the commercial banks in the economy. In essence, the repo rate is the interest rate that the RBI charges a commercial bank when it borrows money from the RBI. As such, if the repo falls, all interest rates in the economy should fall. And that is why common people should be interested in the RBI’s monetary policy.
But the interest rate for consumer loans has not reduced by 110 bps since February. Why?
In the real world, the “transmission” of an interest rate cut (or increase) is not a hundred per cent. And that is why, even though when the RBI cut by 35 bps on Wednesday, lay consumers may only receive a much lower reduction in the interest rate on their borrowings. This is due to a lot of factors — but primarily, it has to do with the health of the concerned commercial bank.
Over the past few years, almost all banks, especially the ones in the public sector, have seen their profits plummet because many of their past loans have turned out to be non-performing assets (in other words, they are not getting repaid). To cover for these losses, the banks have to use their existing funds, which would have otherwise gone to common consumers for fresh loans.
There is another key element that affects the banks’ decision. The reduced repo rate applies only to new borrowings of banks. The banks’ cost of existing funds is higher. Of course, funding costs would eventually come down — but this process would take time. This “lag” in monetary policy is a key variable in determining the efficacy of any rate cut by the RBI. It could take anywhere between 9 and 18 months for the full effect of an RBI decision to reflect in interest rates across the economy.
So, how does RBI decide the interest rate?
Any central bank has a few main concerns.
The first is to ensure price stability in the economy. Think of how chaotic life would be if there was no predictability about the prices of everyday items. The interest rate anchors the prices in an economy. The RBI continuously maps prices, inflation (which is the rate of increase in prices), and expectations of inflation (of households) to decide if it should increase or decrease interest rates.
For instance, the RBI announced some years ago that it would like the inflation rate to be 4%. So, every time the retail inflation rate rises above the 4% mark, the RBI realises that there is too much cash chasing too few goods in the economy. To set the matter right, it raises the cost of money — that is, the interest rate. When it does that, some people find it more advisable to put the cash out of the market and into banks. This way, inflation falls. The reverse process applies when the inflation is below the 4% mark.
The other related concern for a central bank is to take care of economic growth. For instance, economic growth is anaemic at present (see charts), and partly as a consequence, the inflation rate has been below 4% for several months now. The RBI is, therefore, cutting interest rates to incentivise people to consume more and businesses to invest more.
Will the rate cut bring investments?
Investments depend essentially on the “real” interest rate. The real interest rate is the difference between the repo rate and retail inflation. When making an investment decision, it is this interest rate that matters. As a variable, it allows an investor to compare the attractiveness of different economies. As can be seen in the third chart, real interest rates in India have been rising, and that is one of the biggest reasons why investments are not happening. The RBI’s move on Wednesday would reduce the real interest rate and hopefully attract more investment.
Relevant for GS Prelims & Mains Paper III; Economics