Why the business media is obsessing over RBI cutting rates and how it affects you

The pink papers are once again speculating about whether the Reserve Bank of India will announce a rate cut. Media reports suggest that the central bank’s monetary policy committee may declare a decision to this effect on Wednesday. How does this concern those who do not read the business papers?

The rate in question is the repurchase rate or the repo rate. This is the rate at which the central bank lends money to commercial banks, usually in exchange for government securities.

So, a rate cut means a reduction in the rate of interest at which banks such as the ICICI and State Bank of India get money from the RBI. Once this rate goes down, the banks are in a position to give loans at lower interest rates to individuals and the industry. After all, commercial banks are in the business to make a profit and can do so only when they keep their lending rate higher than the rate at which they borrow money.

Let’s assume a bank is currently lending to customers at an 11% interest rate and is borrowing from the RBI at 6.25%. If the RBI lowers the rate at which it lends to banks by 0.25%, banks can pass on the benefit of this to customers. So, they can offer loans at a 10.75% interest rate instead of 11%. Similarly, if the RBI raised the repo rate, the banks would have to increase interest lanes on loans to maintain their profit margins.

How do rate decisions affect you?

The monetary policy committee of RBI decides this repo rate every two months. They can leave it unchanged (as they did last time) or can choose to increase or decrease it. The committee also looks at the state of the economy and inflation levels while deciding on whether to change interest rates. A rate cut can increase liquidity in the economy and hence drive up the cost of goods and services, so the RBI often uses this monetary policy tool to control inflation.

The decision on repo rates has wide-ranging implications for businesses and individuals. A lowered repo rate means businesses are likely to borrow at cheaper rates from the banks. Similarly, individuals borrowing from the formal sector also stand to gain from cheaper credit if rate cuts by the RBI get passed on to them through consumer loans.

However, a big question is whether the banks will pass on the benefit of a rate cut to consumers. A study by the International Monetary Fund said that there is a “significant, albeit slow, pass-through of policy rate changes to bank interest rates in India”. Former RBI Governor Raghuram Rajan went on record to say that cutting rates aggressively won’t work if banks don’t pass the rate cut on to consumer.

Who decides if rates should be changed?

Until last year, the RBI governor would decide whether to go for a rate cut in consultation with a technical advisory committee. The technical committee’s role was only advisory in nature as the governor could veto its decisions. But the system was changed last year when the RBI adopted a new inflation-targeting regime, which requires the central bank to keep consumer inflation at 4% or below, with a 2% room on either side to allow for temporary volatility.

Under the new system, a six-member monetary policy committee, with three top RBI officials (including the governor and deputy governor) and three government nominees, was made responsible for fixing the repo rate. For the last year, the committee has been meeting once every two months to take a decision on the repo rate keeping in mind the central bank’s dual objective of controlling inflation while ensuring that economic growth is not affected.

The members vote on proposals and the majority vote wins, while the central bank governor, who is the chairperson of the committee, gets the deciding vote in case of a tie.

Has the transition to the monetary policy committee been smooth and effective?

While economists expected a monetary policy committee to bring stability and resilience to the process of deciding RBI’s rate decisions, there have been controversies surrounding the formation of the committee.

In 2016, there was a lot of back and forth about the composition of the committee. It was earlier proposed that there would be two members nominated by the government, which was later increased to three. There were also fears that the committee’s decisions would get influenced by the presence of government-nominated members.

What are the major factors that will influence the committee’s decision on the rate?

Inflation levels have been low over the past couple of months. Consumer prices rose just 1.5% in June even as the RBI forecast a range of 2%-3.5% inflation for April-September. This could encourage the bank to relook at its hawkish strategy of countering inflation by keeping rates high.

Second, capital investment in the country is growing at a slow pace. Total investment increased by just 5.18% in the year ended March 2016, as compared to 11.8% in the financial year before that. Bank credit growth reached its lowest level in 60 years at 5.1% in the year 2016-’17 financial year. Thus, the economy needs a little bit of reviving and a reduction in interest rates could help.

There are also global factors. Many are seeing this as RBI Governor Urjit Patel’s last chance to cut rates before the US Federal Bank starts reducing its balance sheet, which is likely to put pressure on emerging markets like India to keep pace with investments and growth. The American central bank is planning to gradually sell of bonds worth $4 trillion it acquired to revive the economy during the 2008 recession, which would drive up prices and interest rates.

What will the RBI do?

Before its last announcement on rates in June, the RBI recently showed that it is in no mood to give into pressure as the monetary policy committee unanimously refused a meeting with the finance ministry scheduled for June 1. Eventually, the RBI kept the rates unchanged, at 6.25%. While the consensus among economists this time around is that a rate cut is likely, the central bank could spring a surprise.

For instance, experts such as Rathin Roy, Director, National Institute of Public Finance and Policy, have pointed out that RBI has been inconsistent and has used the same set of data and policy situations to argue for two different decisions with regard to a change in interest rates.

“The MPC [Monetary Police Committee] appears to have reversed its stance on inflationary expectations and reversed its call on the transitory effects of demonetisation,” Roy wrote on June 8. “It seems to have taken a new normative call on the effectiveness of monetary policy in the presence of structural constraints that have been present for some time now.”