Home / Markets / Mark To Market /  How effective are RBI rate hikes?

On Friday, the Reserve Bank of India’s (RBI’s) monetary policy committee (MPC) raised the repo rate by 50 basis points to 5.4%. The repo rate is the interest rate at which the RBI lends to commercial banks. One basis point is 0.01%. With this, the repo rate is now higher than in February 2020, the initial stages of the covid pandemic.

When the RBI raises interest rates, the hope is that it will translate into banks raising their lending rates which will make borrowing expensive and, in the process, dampen demand. With lower demand, less money will chase the same set of goods and services, translating into a lower rate of price rise or lower inflation.

Theory vs practice
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Theory vs practice

So, is that happening? As of 15 July, the annual non-food credit growth stood at 13.5%, which isn’t exactly slow. Banks lend to the Food Corp. of India and other state procurement agencies to primarily buy rice and wheat directly from the farmers. What remains is non-food credit.

Interestingly, non-food credit growth has only picked up as the RBI has raised the repo rate over the last few months. It could very well be argued here that the low-base effect is at work. At the same time last year, the economy was going through the after-effects of the second wave of the pandemic. But even if we look at two-year and three-year non-food credit growth rates, they are growing faster than in the past.

One reason for this could be that banks haven’t passed on the repo rate increase to their borrowers. But, this isn’t true.

Commercial banks’ weighted average lending rates on fresh rupee loans in June stood at 7.94%, 43 basis points higher than in April. Moreover, news reports and anecdotal evidence tell us that lending rates have increased since then.

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The second reason could be that monetary policy takes time to become effective at the ground level. That being the case, the RBI should have started raising interest rates a while back instead of waiting as long as it did.

Interestingly, in a column published in May on the Mint Views pages, economist Madan Sabnavis looked at past data and concluded that “high repo rates did not really slow growth in credit extended by the banking system".

Ultimately, prospective borrowers are more likely to borrow if they feel they will be able to repay their loans. This depends on their confidence in their economic future and has a very weak link with the repo rate, especially if a central bank is behind the curve.

On the flip side, as always, banks are making the best of this situation. They have quickly upped their lending rates but are going slow on raising the deposit rates.

In April, the lowest and the highest term rates for deposits of more than one year varied between 5% and 5.6%. As of July end, they had moved marginally up to 5.3-5.75%.

If we look at the weighted average domestic term deposit rates of commercial banks, they had barely moved from 5.03% in April to 5.13% in June, an increase of 10 basis points. As mentioned earlier, lending rates on fresh domestic loans during the same period had moved up by 43 basis points. Clearly, banks up lending rates as soon as the RBI starts raising the repo rate, but for deposit rates, they wait for the market dynamics to catch up.

As the data cited in this piece shows, maybe we are devoting much more time and attention to parsing RBI’s monetary policy actions than they deserve.

Elsewhere in Mint

In Opinion, Manu Joseph replies to free-speech warriors. Mythili Bhusnurmath says MPC is out on a wing and a prayer. Long Story has a cheeky take on the jargon of stock market.


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