As a layman what is one to make of the credit policy? Credit policies are all about deciding on the repo rate which is the benchmark used as part of the toolkit for ensuring macro-economic stability by the central bank. The repo rate, which is nothing but the rate at which the RBI lends to banks on an overnight basis, is the anchor rate. It is just like the Fed rate which is similar in scope. What these anchor rates do is to guide the direction of movement in all other interest rates in the financial system.
As far as banks are concerned the repo rate becomes the anchor to decide on all other interest rates concerning their deposits and lending rates. The lending rates of banks are driven by two sets of factors. The first is what are called external benchmark lending rates where the interest rate is fixed to a benchmark which is normally the repo rate. It could also be the yield on a security or Treasury bill. Therefore any change in the repo rate would automatically tend to move the lending rate for all banks for loans that are tied to this formula. By statute all retail loans and those to MSMEs are linked to this benchmark.
The second is what is called the MCLR which is the marginal cost lending rate that is a formula-based rate. Here the lending rate is based on the marginal cost of funds which is primarily the deposit cost with other variables being included. This is the minimum rate at which anyone can borrow from a bank and normally there is a spread over the MCLR. Therefore it could be in the range of 50-300 bps and can stretch higher given the risk profile of the customer.
Intuitively it can be seen that what matters here is the deposit rate which is again linked somewhere to the repo rate. The credit policy was eagerly awaited this time because conditions looked seemingly appropriate for expecting some action on the repo rate given that the last two inflation numbers for July and August are less than 4%. The RBI has decided not to change the repo rate which will remain at 6.5%. Therefore, there is no policy push to alter the lending rates as of now.
However, after a long hiatus the stance has been changed to neutral. The stance is something which has been debated for quite some time now. It has been kept as ‘withdrawal of accommodation’ ever since the Ukraine war started. It has been interpreted as a position taken when the RBI is waiting for all past actions on repo rate — the increase by 250 bps invoked since 2022, to be transmitted to the deposit and lending rates.
A ‘neutral’ stance can be taken to be interpreted as the central bank being comfortable with the present state of the system where transmission of interest rates is more or less complete and there is reason to look at rolling back rates when the time is opportune. Here, the policy actually blows hot and cold. There is a lot of caution being expressed over the future course of inflation. The high base effects kept inflation low in July and August and the expectation is that inflation will cross 5% in September. Further the forecast for inflation for Q3 of the year is 4.8% which is much higher than what was witnessed in the first two quarters. This gives a sense of caution that a rate cut cannot be in the offing any time soon.
The RBI has highlighted three factors which can be influencing inflation in times to come. The first is the impact of climate which has manifested in extreme heat and rains in different parts of the country. The potential to affect agricultural output is high, and this is already seen for tomatoes and onions. The second is the geo-political situation which is becoming unstable ever since the Israel issue has resurfaced with Iran getting involved. The potential impact on crude prices as well as logistics costs is sharp and cannot be conjectured at present. Last, there has been a tendency for global commodity prices to rise which will feed into the costs of manufactured goods and increase core inflation.
What does all this mean? It appears that the RBI believes that the worst of high inflation is over. But there is some uncertainty on the durability of the present low inflation and therefore there will be a wait and watch approach. The fact that the stance has been changed to neutral is indicative that a rate cut would be on the horizon, as a stance change prepares the system for a rate change which can be only in the downward direction.
Therefore, one can assume that the era of ‘peak interest rates’ may have ended. Therefore from the point of view of borrowers the picture is clear. The lending rates will only come down though the timing is hard to guess. But from the point of view of deposit holders, it may not be very clear. While deposit rates in general are unlikely to increase across all banks and tenures, the downward movement would also not be generalised. This is so as liquidity conditions vary across banks. While system wide liquidity is comfortable, individual banks are using other means of raising funds including raising deposit rates across specific tenures. Hence it is still possible for certain banks to offer higher rates on some deposits.
In a way it can be said that we may be starting on the cycle of lower rates in future. Going by the inflation forecasts of the RBI and the current geo-political situation, a rate cut is possible earliest in February 2025. While this would be good news for borrowers, it should also be mentioned that in this particular cycle of lower rates, the repo rate cuts could sum to 50 bps as 6% repo rate has been the average over the years. Anything lower could at best be temporary, as inflation would always be a variable that would be hard to keep low for all time.
The author is Chief Economist, Bank of Baroda and author of ‘Corporate Quirks: The Darker Side of the Sun’. Views are personal
