What Does the “Rate Cut” Mean?

by Harsh Vora - Jan 19, 2015 11:19 AM
What Does the “Rate Cut” Mean?

The Reserve Bank of India’s announcement of lowering the lending rate for banks means lower EMIs for the middle class. Industrial production and economic growth should get a boost too. The downside is the possibility of higher inflation.

Economics and, to a certain extent, finance — unlike the physical sciences such as physics and chemistry — are really not too difficult for the laymen to comprehend. They shouldn’t be because these subjects guide public policymaking to a great extent and ultimately have an impact on the ordinary citizen’s life at a granular level.

When you interrupt a conversation among friends about the previous night’s football match with “Hey, did you hear that the repo rate has been cut by the RBI? I am so glad economic growth will now assume speed”—you’re only going to make them suspicious and rethink whether they should invite you to the next coffee get-together.

So this is an attempt to bring clarity on a recent issue that is being debated confidently by every intellectual and commentator, but still somehow continues to remain unclear to the laymen – people who will ultimately be affected by it: Reserve Bank of India (RBI)’s announcement of a “rate cut”.

Raghuram Rajan finally announced a rate cut.
Raghuram Rajan finally announced a rate cut.

The decision was announced Thursday morning, and by the end of the day, the stockmarket rose by close to 700 points while the rupee appreciated to 61.48 against the US dollar (that is, the rupee became cheaper, which is good for exporters and bad for importers, but that’s another story). Industry experts, government, as well as economists cheered the decision. Clearly, it’s widely seen as a positive development. However,

What exactly is the “rate” in the “rate cut”?

The rate that was reduced by RBI goes by several names. It is called the policy rate but also the repo rate. So when you hear any of these terms, remember that it refers to the same rate.

What does policy rate or repo rate mean?

One of the functions of the central bank is to control and direct the “cost of credit”, which is simply the interest rate at which individuals or businesses borrow funds from the commercial banks such as State Bank of India or ICICI.

But these commercial banks often borrow funds from the central bank (RBI) for their short-term needs (usually 7 to 14 days or even overnight). The interest rate at which the central bank lends to these banks is called the repo rate or the policy rate.

This is the rate which determines the overall cost of credit in the economy. It becomes a floor, below which short-term lending does not go.

On Thursday, this rate was reduced from 8 per cent to 7.75 per cent. But in financial jargon, the rate reduction is measured in ‘basis points’. One basis point is one-hundredth of one percentage point. So when you hear them say that the rate was cut by 25 basis points, it means it was reduced by 0.25 per cent.

So why all the brouhaha about it?

As standard practice, all changes in the monetary policy (changes in interest rates and some other ratios) are announced in the bimonthly reviews held by the RBI.

But this time, it was announced outside the review. This surprised market participants who expected RBI Governor Raghuram Rajan to wait until the Union Budget is presented in February-end. That is because the Budget, it is believed, would have helped the governor better gauge the condition of the economy.

But why do I hear the word ‘inflation’ alongside ‘rate cut’. Are they related? If so, how?

A higher policy rate means commercial banks may have to pay a higher interest rate on funds they borrow from the central bank. To compensate for this, the commercial banks will raise their own base rate (below which they cannot lend to borrowers such as you and me).

Companies, too, have to bear the brunt of the higher repo rates. Since their borrowing costs rise, they either have to delay the borrowing or suffer from lower profits on account of higher interest expenses, or cut other costs (which may include jobs). A delay in borrowing plans is followed by a delay in capital projects such as purchasing machinery, building production plants, and so forth.

This fall in investments in important projects by companies in turn translates into lower production. This results in lower wages, and consequently lower demand for products and services. This causes inflation to reduce, as we have seen in recent months.

The higher policy rate that the Indian economy witnessed since May 2013 is believed to have partly contributed to lowering the retail inflation to 5 per cent in December, from a high of close to 11 per cent in 2013. Of course, there are other factors influencing inflation such as the price of crude oil, the monsoon, government policies which either impede or encourage production etc.

A higher policy rate, by making it difficult—or less attractive—for companies and individuals to get credit, pulls the money out of the system (which is why it is referred to as ‘tight’ monetary policy). And since the supply of money reduces in the economy, the value of each rupee increases—it can purchase more goods, in effect reducing inflation.

The reverse is true when interest rates are reduced (called loose monetary policy). This results in more money into the system. A higher supply of money, compared to its demand in the economy thus devalues the rupee. Each rupee can now buy fewer goods, thus stoking inflation.

But I also hear them speaking about ‘growth’…

As mentioned on RBI’s website, one of its central objectives is “to maintain price stability and ensure adequate flow of credit to productive sectors.”

These are two distinct yet interrelated goals. While RBI attempts to control inflation and the general rise in prices, it has to make sure the rise in policy rate does not stall the economy by discouraging credit. Hence the words “ensure adequate flow of credit to productive sectors”.

Just as a higher repo rate causes prices to fall, but also discourages investment by companies, a lower repo rate (or a rate cut) is said to encourage investment by companies in various projects — since they can now borrow funds at a lower rate. Greater investment by companies leads to higher production, which in turn results in higher wages, and higher demand, which in turn increases economic growth.

Too much demand, however, is seen as spurring the general prices of goods—of fuel, food, durable, non-durable items, and so forth—to rise, which then prompts the RBI to consider raising rates.

So, in effect, RBI tries to maintain a balance between inflation and growth. Lower inflation comes through higher interest rates (among other factors). But higher interest rates impede economic growth. Lower interest rates encourage growth but may stoke inflation. This is why the central bank has a rather difficult task of maintaining “comfortable” inflation while also encouraging economic growth.

Yes, all right, but how will this affect me?

Economic growth, which is partly spurred by a lower policy rate but equally also by government’s policies, has an impact on every one of us. It entails more jobs, higher wages, and greater purchasing power. More specifically, however, it is expected to lower the EMI costs of home loan borrowers amongst us.

The recent cut in policy rate will result in commercial banks lowering their deposit rate, an act that will be followed by a cut in lending rate. For floating rate borrowers, the lending rate will reduce, although we cannot precisely say when. It varies from bank to bank.

For fixed rate borrowers, however, there will not be any change in EMIs but they can resort to taking a fresh loan from another bank at the lower interest rate. This process should not entail any additional pre-payment and other fees.

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