BackWhy Raghuram Rajan may hold rates
A cut in interest rates may not actually transmit to increased lending by banks and financial institutions
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John H. Cochrane, an economist and professor of finance at the University of Chicago’s Booth School of Business, has an interesting take of the non-event of the US Federal Reserve failing to raise the benchmark overnight lending rate in its decision last week.
He writes on his blog:
Banks are lending the Fed about $3 trillion worth of reserves, which they could lend elsewhere had the market been producing great opportunities. Spreads of other rates over the rates banks lend to or borrow from the Fed are low, not high. Deposits are flooding into banks, not loans out of banks.
If you just look out the window, our economy looks a lot more like one in which the Fed is keeping rates high, by sucking deposits out of the economy and paying banks more than they can get elsewhere; not pushing rates down, by lending a lot to banks at rates lower than they can get elsewhere.
Most commentary on interest rate decisions by central banks hinges on analysing the situation of the macroeconomy in terms of inflation and growth rates.
Factors such as the effectiveness of monetary transmission, or how a change in rates can actually impact growth is working, are usually given short shrift.
In this context, Cochrane’s analysis of the demand and supply of short-term deposits at the Fed is pertinent.
With the Indian Consumer Price Index showing its lowest level of growth in four years, and with growth rate not as high as expected, there is strong expectation that Reserve Bank of India (RBI) governor Raghuram Rajan (incidentally, like Cochrane, an economist and professor of finance at the University of Chicago’s Booth School of Business) should cut benchmark lending rates.
There are reasons to infer from his recent statements, however, that he is not too keen on the move. Looking at the demand and supply of short-term deposits at RBI might give us some insight into the governor’s actions.
Every night, banks park their excess funds overnight with RBI, for which they get paid interest at the reverse repo rate.
On the other hand, if banks are running short of funds, they borrow overnight from RBI, for which they pay interest at the repo rate. Thus, by way of determining the opportunity cost of funds for the bank, the central bank uses the repo rate as an instrument of orchestrating monetary policy.
If we subtract the money parked at RBI on a given day from the money lent out by RBI on the same day, we get the net injection of funds by RBI into the market on the particular day. If this net injection is positive, it implies that demand for funds is higher than supply (at the given rates), or that banks are lending aggressively.
If RBI was to take the signal from the market (the direction of causality—whether RBI adjusts rates based on demand and supply or vice versa—is not known), sustained positive net injection is a suggestion to raise rates.
Similarly, sustained negative net injection means that banks prefer to lend to the central bank than to the markets at the current rates, and is an invitation to cut interest rates.
As Cochrane notes, the US has been seeing sustained negative net injection, despite all the stories of the recovering economy and falling unemployment there. Thus, a rise in the federal funds rate there would have further skewed this imbalance, and holding the rates is justified. The question is whether the market for reserves in India is suggesting an aggressive rate cut as most commentators are.
Chart 1, which shows the net injection of funds by RBI in the last decade or so, overlaid with the prevailing reverse repo rate, suggests some interesting patterns.
Until the global financial crisis in late 2008, the net injection varied but mostly hovered near zero (there is one interesting play in that period where rates were raised after sustained positive net injection, which led to sustained negative net injection. RBI had held firm then, though, and net injection stabilized close to zero).
When the global crisis hit, RBI responded by dropping rates in a series of steps, with the reverse repo rate bottoming out at 3.25% in early 2009.
Yet, the graph shows despite the rate drops, net injection was largely negative for a sustained period following this. In other words, though it was cheap for banks to lend, the extent of the global financial crisis meant they preferred to keep their money with the central bank. This piece of data can also be interpreted to mean RBI didn’t drop its rates far enough.
Then RBI governor D. Subbarao started raising rates in early 2010, rapidly increasing them in a series of steps until the reverse repo rate hit 7.5% in late 2011.
The net injection crossed into positive territory in this time period; interestingly, it stayed consistently positive for a significant amount of time, until late 2013. This lends credence to hypotheses that RBI under Subbarao perhaps didn’t raise rates enough, or quickly enough, after the global financial crisis, which led to an overheated economy and sustained inflation.
Since the beginning of 2014, however, the net injection marker has been hovering around zero, indicating that RBI hasn’t been too wrong in its rate setting.
Daily variations remain, as chart 1 shows, but if one looks at chart 2, which shows broad trends in net injection (oscillations having been smoothed out using Loess functions), the market is well balanced. It is not hard to see there that net injection has been close to zero since the beginning of 2014.
In other words, while there might be heavy rhetoric among politicians, businessmen and economists clamouring for a big rate cut, the market simply doesn’t support this claim.
If banks truly believed that the only thing holding back lending was high repo rates, they should have been pushing net injection significantly negative.
That this is not the case implies that a cut in interest rates may not actually transmit to increased lending.
There shouldn’t be any surprise if RBI decides to hold interest rates in its next policy review.
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