Published in DTNext on Oct 6, 2016
Among the many tug-of-wars between the government, and the rock-star central banker Raghuram Rajan was the latter’s steadfast refusal to drop interest rates. Of course, when he demitted office he partly acquiesced. His successor, and the one with who Rajan played tango at the RBI, Urijit Patel, has now reduced the rate further by 25basis points.
This rate cut means that the cost at which banks borrow from the RBI will fall straight away by 0.25%. Consumers are expected to receive the benefit of this fall. However, the rate change is only a guideline for banks to change interest rates and they may choose not to do so.
The cut has significant influences. First, interest rates on bank deposits will fall. This fall would hurt the renter class, that is, those who rely on fixed income. The deposits already taken will not be affected. Secondly, bonds coming up in the future may price themselves lower by 0.25%. This would mean that if you already invested and holding some bonds, their value will go up because you are earning a higher rate compared to market price. Thirdly, if you are on a floating rate loan, like a housing loan, the loan should now technically cost you less. It would be less by 0.25% if the entire benefit were passed on. For fixed-rate mortgages, there will be no impact on the EMI. Finally, the interest rate on loans by banks to people should fall.
Changing the rate influences the supply of money by banks and to consumers. Typically a rate cut is done to stimulate growth. A lower cost of money encourages borrowing. But if the rates are too low they can spur too much growth leading to inflation.
In retrospect is the cut good? That depends on whether you are predominantly an investor or borrower. If our GDP were growing at 8%, there would be no need for a rate cut. Again what’s important is will the banks pass on the benefit or will they use it to shore up their financials? For instance, since Jan 2015, the RBI has cut rates by 1.75 percentage points, but home loan rates have fallen only by 0.85 percentage points. And deposit rates have been reduced by 1.35 percentage points.
Therein hangs a tale.