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Subbarao’s surprise cut

Subbarao’s surprise cut
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First Published: Tue, Apr 21 2009. 06 00 PM IST
Updated: Wed, Apr 22 2009. 12 58 AM IST
The unexpected decision by the Reserve Bank of India (RBI) on Tuesday to cut its two policy rates by 25 basis points each has two implications.
One, the central bank has sent a signal that it is more worried about low growth than inflation. Two, it has reduced the incentive that banks have to park money with the central bank rather than lend it to companies, consumers and homeowners.
RBI has now cut short-term interest rates by 4.25 percentage points since it started easing monetary policy in October. The usual assumption is that banks will pick up the cue and reduce the interest rates at which they lend to the real economy. That has not happened. The problems in the monetary transmission mechanism have ensured that bank-lending rates have fallen by not more than 150 basis points. A basis point is a hundredth of a percentage point. Banks have also preferred to park money with the central bank rather than lend.
There are several issues here that a reduction in short-term interest rates will not solve. Banks are genuinely worried that a lending binge right now will lead to a mountain of bad loans down the line. The politically sensitive interest rates of small savings schemes such as the public provident funds act as a floor on deposit rates. Finally, the government’s borrowing binge has resulted in an oversupply of government bonds in the market.
Our own view is that RBI had little practical reason to cut interest rates right now—other than signalling its worries about weak economic growth. We feel that the central bank is close to the end of its rate-cutting cycle; interest rates may go down further from here but the movement will be incremental and gradual.
RBI goes into slightly more unsure territory from now on, as the pace at which economic activity is shrinking eases and inflation bottoms out. It will then have to stand up to huge pressure to let go of caution—especially if an unstable coalition comes to power in June.
The good thing is that RBI has not yet fallen prey to the pressures on it to irresponsibly print money to finance the government deficit. The bank should continue to hold its ground on this issue.
Does RBI have space to bring down interest rates even more? Write to us at views@livemint.com
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First Published: Tue, Apr 21 2009. 06 00 PM IST