Rate Cut By RBI Explained

Rate cut by RBI explained

Many of you might have been left with your heads scratching after reading the term-  ‘Rate cut by RBI’s Monetary policy committee’. Now, what do we mean by rate cut? The rate in question is the repurchase rate or the repo rate. This is the rate at which the central bank lends money to commercial banks, usually in exchange for government securities.

So, a rate cut means a reduction in the rate of interest at which banks such as the ICICI and State Bank of India or any other bank  get money from the RBI. Once this rate goes down, the banks are in a position to give loans at lower interest rates to individuals and the industry. After all, commercial banks are in the business to make a profit and can do so only when they keep their lending rate higher than the rate at which they borrow money.

Let’s assume a bank is currently lending to customers at an 11% interest rate and is borrowing from the RBI at 6.25%. If the RBI lowers the rate at which it lends to banks by 0.25%, banks can pass on the benefit of this to customers. So, they can offer loans at a 10.75% interest rate instead of 11%. Similarly, if the RBI raised the repo rate, the banks would have to increase interest lanes on loans to maintain their profit margins.

How do rate decisions affect consumers?

The monetary policy committee of RBI decides this repo rate every two months. They can leave it unchanged (as they did last time) or can choose to increase or decrease it. The committee also looks at the state of the economy and inflation levels while deciding on whether to change interest rates. A rate cut can increase liquidity in the economy and hence drive up the cost of goods and services, so the RBI often uses this monetary policy tool to control inflation. If the inflation levels are high, RBI’s MPC will increase the rate. This will cause the banks to increase their lending rates. And, will ultimately decrease inflation levels and vice versa.

The decision on repo rates has wide-ranging implications for businesses and individuals. A lowered repo rate means businesses are likely to borrow at cheaper rates from the banks. Similarly, individuals borrowing from the formal sector also stand to gain from cheaper credit if rate cuts by the RBI get passed on to them through consumer loans.

However, a big question is whether the banks will pass on the benefit of a rate cut to consumers. A study by the International Monetary Fund said that there is a “significant, albeit slow, pass-through of policy rate changes to bank interest rates in India”. Former RBI Governor Raghuram Rajan went on record to say that cutting rates aggressively won't work if banks don’t pass the rate cut on to consumer. So, ultimately, it is the passing of rate cuts which will make a difference as far as inflation levels are concerned.