Monetary policy: Key takeaways

A layperson, with reasonable education and knowledge of current affairs, who tries to read the RBI policy document of April 5, 2016 could find it quite daunting.  She will understand that her bank will probably pay lower interest on her deposits. It may bring down interest rates slightly when she goes for a home loan or a car loan. She also reads that the RBI has brought down its policy rate from 8 per cent in January 2015 to 6.5 per cent now. So she expects that her home loan interest rate would also come down to the same extent – by 150 basis points or 1.50 percentage points.

But what else does she get from the policy document?  There is some comfort that inflation is under control and will continue to remain so, especially food inflation. But she fears that services inflation may go up, thereby implying that her education bills and medical bills may increase.  There are worries that the job market may not be so good in the manufacturing sector; but there could be some opportunities in the services sector. Agriculture is expected to do reasonably well, which she hopes will keep food bills under control. Her inflationary expectations, she notes, as reflected in the survey done by the RBI have come down.

If this is all the statement contains, why so many paragraphs? Why is there so much emphasis on liquidity and liquidity management? What does transmission mechanism mean and why is it so important?

RBI operates its monetary policy through the repos rate. This is the rate at which RBI provides money to banks for the day-to-day liquidity to manage their operations. The repos rate that was 8 per cent in January 2015 has been reduced to 6.5 per cent on April 5.  Normally it is expected that this reduction will be reflected in the banks’ interest rates.  In January 2015, SBI’s one-year deposit rate was 8.50; today it pays 7.50 for a one-year deposit. But the home loan rate, which was 10.15 per cent in January 2015, has been brought down only by 65 basis points to around 9.5 per cent. Monetary policy will be effective only when there is transmission of changes in the policy rate to bank lending rates.

It is very significant that the RBI is now stating that “the past rationale for keeping the system in significant average liquidity deficit no longer is as compelling, especially when the policy stance is intended to be accommodative”. Hence the announcement that RBI will move to a neutral stance on liquidity is hugely positive and will ensure that the transmission mechanism works much more smoothly. This is the best part of the policy and will have much more impact than what even another 25 bps reduction in the report could have had!

Hence if the RBI feels that interest rates should be lowered keeping in view that inflationary pressures are reducing and expectations are getting softened, the impact on the economy will be felt only when the lending rates come down and stimulate credit demand. This is why transmission is important.  One of the ways that transmission has been hampered is the way deposit rates and loan rates are set. In case of deposits, the higher rates offered earlier will continue to be paid till maturity, even though the rates for new deposits are lowered. However, loan rates are usually set in relation to base rate.  When the RBI reduces the policy rate, banks are reluctant to reduce their lending rates immediately. This is because they still need to pay higher rates on their existing deposits which constitute the bulk of their resources. They will reduce do so only when they feel that their average cost of deposits has come down.  This can take long especially if they have consciously allowed higher rates on their longer- term deposits. 

This is why the RBI has come out with the new policy of marginal cost based lending rate (MCLR), effective April 1, 2016. According to the RBI guideline, “Banks will review and publish their MCLR of different maturities every month on a pre-announced date.” In calculating their marginal cost banks have to take the cost they are paying currently on their deposits (and not the average rate on the aggregate deposits) and the cost of borrowing wholesale funds (including repos rate). So if one takes a home loan based on the three month MCLR, the rate will be re-fixed every three months depending on the three month MCLR.  This will hopefully make banks more conscious about their asset liability management and pricing of their deposits and loans including the spread for different maturities. This will also help the repos rate or the policy rate translate into lending rates quicker than what happens now especially in a falling interest rate cycle.

The most significant aspect of the monetary policy of April 5 is its focus on ensuring that the transmission works by making sure that there is sufficient liquidity in the system.  This will makes banks comfortable about reducing their rates without worrying about shortage of liquidity if the demand for credit goes up and they have funds constraint. The RBI had been keeping the system in a liquidity deficit mode.  It is very significant that the RBI is now stating that “the past rationale for keeping the system in significant average liquidity deficit no longer is as compelling, especially when the policy stance is intended to be accommodative”. Hence the announcement that RBI will move to a neutral stance on liquidity is hugely positive and will ensure that the transmission mechanism works much more smoothly. This is the best part of the policy and will have much more impact than what even another 25 bps reduction in the report could have had!

(The writer is a former Deputy Governor of the Reserve Bank of India)