The lack of efficiency in monetary policy transmission has been a pressure point for the central bank. Since January 2015, the Reserve Bank of India (RBI) has cut the policy rate by a total of 125 basis points (100 basis points make one percentage point), but bank lending rates in that period came down by only 60 basis points. Bankers have argued it was the same when policy rates were being hiked: banks increased rates by less than the policy rate. Be that as it may, the RBI has decided to change things. To address truncated monetary policy transmission, it announced last week that banks will now be required to compute lending rates based on the marginal cost of funds - instead of the current practice of using average cost - and will have to publish these rates on a monthly basis. The move must be welcomed because it is expected to increase transparency and promote competition in lending markets. Similar arguments were used in 2010, to explain the shift from benchmark prime lending rate to the base rate system. Perhaps the new edict will be more effective.
However, is the RBI doing all that is needed to ensure the efficacy of monetary policy? There are two notable features of the 125-basis-point rate cuts by the RBI. First, there have been apparent inconsistencies between the rate cuts and monetary policy commentary on the likely trajectory of inflation and interest rates. Second, out of the 125 basis points, 50 points were cut through out-of-turn monetary policy statements. Changing interest rates is a complex matter for banks. All product designs have to be reviewed, broader economic considerations revisited, and board decisions have to be re-taken. These tasks get complicated when the central bank cuts rates but simultaneously in the statement warns about raising rates. To banks, the mixed signal implies that the central bank is hedging its bets, and may undo the rate cut in the near future. Banks may then think it is not worth their while to change rates for an interest rate cut that is likely to be reversed.
Out-of-turn statements are likely to have the same effect on monetary policy transmission. Like mixed monetary policy signals, out-of-turn cuts suggest heightened uncertainty. Banks may then prefer to wait and watch, rather than to act. These problems of the monetary policy process are recent additions to the older shortcomings of the monetary policy transmission, with the lack of a bond market and insufficient competition in the lending business. The international slogan of good monetary policy is "say what you will do, and then do what you just said". The RBI must live by its promise of inflation targeting - and back this up with a well-constructed communication strategy.
1. What do you mean by Monetary Policy?
2. Who formulates Monetary Policy of India?
3. What is Reserve Bank of India? How is it different from other Scheduled Banks?
4. What is meant by policy rates?
5. What is meant by basis points?
6. What is meant by lending rates? What are the current value of lending rates in India?
7. How does lending rate affect the common man?
8. Who regulates the lending rates in India?
9. What is meant by inflation targeting?
10. What are different rates currently being offered in Saving Banks Account/ Fixed Deposit/ Recurring Deposit Account?