Context: Reduction in repo rate needs Monetary Transmission
- The Monetary Policy Committee (MPC) cut the repo rate — the rate at which it lends to the banks – by 25 basis points (bps) to 5.75%.
- The central bank has already cut interest rates twice by 25 bps each this calendar year. The RBI rate cut came after the central bank’s Monetary Policy Committee (MPC) concluded its second bi-monthly monetary policy review for 2019-20.
What is Monetary Policy?
Every alternate month, the RBI meets to decide what course monetary policy should take. Monetary policy is the macroeconomic policy of the RBI. It involves the management of the money supply and interest rate and is the demand side economic policy. Its purpose is to achieve macroeconomic objectives like inflation, consumption, growth, and liquidity.
In India, the monetary policy of the Reserve Bank of India aims at managing the quantity of money to meet the requirements of different sectors of the economy and to increase the pace of economic growth.
Instruments to control the money supply
RBI implements the monetary policy through open market operations, bank rate policy, reserve system, credit control policy, moral persuasion and through many other instruments. Using any of these instruments will lead to changes in the interest rate or the money supply in the economy. Monetary policy can be expansionary and contractionary in nature. Increasing money supply and reducing interest rates indicate an expansionary policy. The reverse of this is a contractionary monetary policy.
For instance, liquidity is important for an economy to spur growth. To maintain liquidity, the RBI depends on the monetary policy. By purchasing bonds through open market operations, the RBI introduces money in the system and reduces the interest rate.
What is Monetary Policy Committee?
Monetary Policy Committee (MPC) is the body of the RBI, headed by the Governor, responsible for taking the important monetary policy decision about setting the repo rate. Repo rate is ‘the policy instrument’ in monetary policy that helps to realize the set inflation target by the RBI (at present 4%)
The recent Monetary policy has two aspects—the stance and the interest rate.
The RBI has clearly moved from a neutral stance to an accommodative one. In common terms, an accommodative stance means the RBI is likely to put in more money in the economy and make borrowing more attractive. The intent is to boost growth within the economy.
When interest rates are low, the interest on loans and the interest earned from deposits decrease.
Who actually needs money at this point?
The government for sure is going to be a borrower. The RBI has created an environment that supports growth; it is the government’s prerogative to come up with policies that make the best use of this environment.
A consumer requires money to buy a car, home & other investments. She benefits because of favorable interest rates.
Attractive investment loans are available for expanding the business. Hence it leads to more production.
RBI’s emphasis :
The RBI has acknowledged that a mere reduction of interest rates isn’t going to fix the economy, what really needs to happen is the monetary transmission. Transmission means that the effect of the RBI’s actions aren’t limited to the banking universe, but should translate as benefits to the common man. If there isn’t enough transmission, the common man can never benefit from better interest rates on loans.
Another pressing concern that policy addresses are liquidity. Liquidity refers to money in the economy. With more liquidity, the government could create infrastructure, businesses could grow, and we could consume more. If there’s too much money in the economy, we might see a phase where inflation picks up—making even day to day goods and services very expensive. The central bank has committed to keeping an eye on liquidity and has already infused money through open market operations in May and swap auctions in April. It is ready to stretching and pushing more money into the economy if required.
Controlled Inflation :
One of the responsibilities of the RBI is to keep inflation under control. A small amount is indicative of a healthy economy, whereas too much becomes harmful. We start worrying about inflation when maintaining our standard of living becomes more expensive. The RBI is quite confident of managing inflation expectations and estimates are within the band in its mandate.
Growth is the last pillar of monetary policy. Globally, we are noticing that many economies are not able to keep pace. Several central banks across the globe have moved to more accommodative policies. So it would make sense to keep tabs on global cues. Growth will be fuelled by better reforms and policies that are to be outlined in the government’s budget. It will also be guided by the wiser allocation of loans by banks and NBFCs.
What is Repo Rate and what is its significance?
What is Repo Rate?
The term ‘Repo’ stands for ‘Repurchase agreement’. Repo is a form of short-term, interest-bearing and collateral-backed borrowing. The interest rate for such borrowings is termed as a repo rate. In Indian Banking terms, the repo rate is the rate at which Reserve Bank of India lends money to all the commercial banks in the country in the event of scarcity of funds. In other words, it is the rate at which Commercial Banks sell their securities and bonds to Reserve Bank of India with an agreement to repurchase the securities and bonds from Reserve Bank of India on a future date at a pre-determined price. The repurchase agreement is signed by both parties involved in the transaction
Impact on the Banking System
Increase in Repo Rate:
Lending rates and deposits offered by banks are impacted by a rise or fall of repo rate. However, it may not have an immediate effect. After analyzing the cost of funds and liquidity position, banks may begin to pass on their interest rate burden to its end customer in the form of elevated lending rates. That means a higher rate of credit for new borrowers. Home loans and other floating rate loans get majorly affected due to rate change. Higher lending rates may lead to a slowdown of the lending business for the banking sector, which will have an impact on their profitability. Post analysis of liquidity position, banks may also hike the rate of bank deposit offered to customers to attract more inflow of funds into the banking system.
Reduction in Repo Rate:
With a lowered repo rate, banks can borrow from Reserve Bank of India at a cheaper rate. As a result, banks may even reduce the lending rates to their customers after analyzing the liquidity condition and the deposit inflows. As bank loans get cheaper, consumers can spend and borrow more with cheaper credit. Increased lending business will boost the profitability of the overall banking system. However, lending rate cut and deposit rate hikes are purely dependant on the bank’s liquidity position and deposit demand from customers.
Impact on the Common Man
Increase in Repo rate:
It becomes costlier for commercial banks to borrow short term funds from Reserve Bank of India. Because of the scarcity of low-cost funds, banks resume lending at a higher interest rate. That means loan becomes costlier for a common man. Hence it leads to reduced consumer purchasing power. At the same time, banks may begin to offer fixed deposits at an increased rate to attract more inflow of funds which leads to higher savings by the people.
Reduction in Repo rate:
With reduced repo rate, loans and advances become cheaper for the commercial banks as they can avail short-term credit from Reserve Bank of India at the reduced rate. The rate cut may push banks to reduce their prime lending rate. Reduction in prime lending rate encourages more borrowers by making credit accessible at lower rates to the common man. With the increased opportunity to borrow, the consumer can spend more and avail loans to achieve future financial goals easily.
Impact on the Economy
Increase in Repo Rate.
- Expensive bank loans discourage the borrower from availing credit. This reduces the money supply in the market and thereby stabilizes the liquidity in the system. This lowers consumption, expansion, and production.
- Expensive credit hinders economic development and GDP growth even though the inflation rate comes under control. Hence, the Reserve Bank of India revises the repo rate regularly to keep the inflation rate under control and also to strike a balance between both economic growth and rising inflation. Here are some of the vital impacts of the increase in repo rate on the economy:–
- Borrowing becomes costlier for banks as they avail short-term credit from Reserve Bank of India at a relatively higher rate.
- – With the costlier credit for banks, they will ultimately lend the consumers at a relatively increased rate. This may lead to costlier bank loans for customers. As the lending gets expensive, the borrower gets discouraged and demand for bank loan reduces.
- Reduced borrowing results in lower consumption demand which will lead to the economic slowdown that hinders the growth of GDP for the short term. As the consumption demand reduces, the profitability of every sector in the economic system takes a hit–
- Corporate loan buyers get discouraged to avail credit with the hike in repo rate. As the availability of business capital becomes expensive, production and expansion plans of corporate take a dip.
An increase in repo rate reduces the money supply in the economic system and thereby reduces the rate of inflation.
Reduction in Repo Rate:
- Short-Term loans for commercial banks become cheaper. This prompts them to offer consumer loans at a relatively cheaper rate
- Many times, the base lending rate gets reduced with the reduction in the repo rate. The base lending rate is the rate below which banks cannot lend to their customers.
- Reduced base rate increases the consumption as people will have more money at their disposal. Increased consumption positively impacts the country’s Gross Domestic Product (GDP) growth.
- Cheaper availability of credit encourages businesses to grow and expand. Prices of products get lower with the availability of low-cost capital. New investments lead to better employment opportunities in the economy. Here are some of the key impacts of a repo rate cut on the economy:–
- Consumption Demand: Demand for auto, housing, and every sector will rise due to the availability of cheaper bank loans to the customer.
- Economic growth will take an upward trend with growth in every sector due to increased consumer demand.
- Economic activities pick up: With the falling prices, the economy grows at a slower rate. Repo rate cut boosts the economic activities and prompts healthy growth with an adequate supply of money in the market.
- – Boost to foreign investments: Bank lending rates get reduced with the cut in repo rate. Lower borrowing rates will encourage foreign players to invest in the Indian financial market.