A high policy rate also means high deposit rates, higher Public Provident Fund (PPF) rates and higher smaller saving rates
Households, in theory, can celebrate a rate cut anticipating a lower rate on their loans
The Reserve Bank of India has cut the benchmark policy rate by 25 basis points (one basis point is one-hundredth of a percentage point) in line with the expectations of the market and economists. Should an average household be happy or sad? An average household catches cues from newspaper headlines and worries when the central bank holds interest rates high for very long without really knowing why. But often the interest of the household is different from that of the corporate sector or banks. This is how it works and why we don’t need to celebrate a rate cut just yet.
We know that a repo rate is the rate at which banks borrow from RBI. Banks give eligible securities they hold for cash that RBI gives as an overnight loan. Banks pay the repo rate as interest for this borrowing. When the repo rate is high, banks find it costly to borrow and in turn raise the price of loans to their borrowers. A high repo rate is used to soak up money from the market when inflation rates are high. As banks raise their own lending rates, firms find it costly to borrow and reduce investment outlays. You may have heard the view that high policy rates are costing India its growth. The view is based on the argument that high policy rates are preventing entrepreneurs from investing into capacity expansion and new business as it raises the cost of the business. The lack of liquidity adds to the problems of finding funds for entrepreneurs looking to invest.
But the world always looks different if you look at it from the household’s point of view. A high policy rate also means high deposit rates, higher Public Provident Fund (PPF) rates and higher smaller saving rates. In fact, Indian households have had the best real return run on their one-year bank FDs, small savings and PPF since 2014. These rates are linked to the government securities rates, which in turn depend on the policy rates. Real return is the post inflation return you get. If inflation is 6% and your FD returns 8%, your real return is about 2%. A high real return keeps your purchasing power ahead of inflation. A negative real return causes you to lose purchasing power. 2009 was the worst year for bank deposit holders who saw a negative real return of as high as -7.22% as inflation reached almost 15% and deposit rates were just half of that. Real returns were largely in the negative territory till 2013. 2014 onwards, as inflation was brought under control, real returns have been positive, reaching an unusual high of 5.02% in 2016. RBI keeping the repo rate high has been good for risk averse deposit and small saving products holders in India. As the rate cuts begin to deepen, expect deposit rates to go down. But remember to check the inflation rate, as long as your real return is at least 1 percentage point over the inflation rate, you should be doing fine in terms of purchasing power. This will work well for people in the lower end of the tax bracket who will not pay income tax till ₹5 lakh of taxable income.
Households, in theory, can celebrate a rate cut anticipating a lower rate on their loans. But don’t get ready to pop the bubbly as your loans don’t get any cheaper when policy rates are cut. This is due to banks tightly controlling the benchmark rates to which your floating rate loans are pegged. These rates go up quickly when RBI hikes policy rates, but don’t float down with the same alacrity. RBI has tried several benchmark regimes to solve this problem of transmission of rates, but the great Indian banks have gamed all of them. The last attempt by RBI has been to get banks to fix retail loans to a benchmark banks cannot control. The result of that move is yet to be seen, but let’s not hold our breath.
You can celebrate the policy rate cut for one reason—that inflation has been tamed.
Monika Halan is consulting editor at Mint and writes on household finance, policy and regulation