The Games Rajan Plays: Decoding Monetary Policy of RBI

With The Great Gruhini’s Guide to Understanding Monetary Policy,you will have much more to look forward in the business papers!

The news about interest rates, economy, growth and inflation are often complex and academical. The only saving grace in these topics is the charming face of the Reserve Bank of India (RBI) Governor, Raghuram Rajan.  

But it could all change in tomorrow’s newspaper. The stories wont look complex and it wont be just the smile to look up to because The Great Gruhini’s “Making Sense of  Monetary Policy” Guide breaks down the complex subject for you.

The connection between Interest rates, Reserve Bank of India (RBI)

In its bi-monthly monetary policy statement announced today, RBI has reduced its repo rate by 0.50% (50 basis points) to 6.75%. It has kept other benchmark rates unchanged. 

Lets first understand the role of RBI. It prints currency notes, controls supply of money in various ways (monetary policy being one way) in the economy. 

RBI fixes the interest rates at which banks can lend and borrow from RBI (repo rates or reverse repo rates). A Repo ore reverse repo facility is like a credit card that works both ways for the bank. Whenever banks need money for a short duration, they borrow it from RBI and pay a repo rate (which is 6.75% now) to RBI as an interest. Conversely if banks have excess cash with them, they can lend it to RBI and earn 5.75 % (a reverse repo rate) on it.

RBI decides the percentage of money that banks should keep aside (cash reserve ratio) so that our deposits are safe. This percentage remains unchanged at 4%

In deciding the level of interest rates, it takes into account various big factors such as international oil prices, amount of exports and imports, the inflation (rate at which prices of good and services go up). On quarterly basis and on bi-monthly basis it studies these factors and announces its stance on the level of interest rates, as it made today.

So in today’s policy statement, RBI hasn’t cut repo rate (8% at present) or the cash reserve ratio (4% at present).

 Why are Interest Rates so important?

The benchmark interest rates as set by RBI, allows banks to fix interest rates it charges on the home loans, personal loans, business loans or loans to companies. if benchmark rates rise, banks follow the same and vice versa.  These rates govern the rates at which we borrow or earn interest.

We Deposit in Banks: When we deposit our savings, salary, cash in the bank. The bank gives us interest for that deposit. Its an expense for the bank.

Banks Lend it Out: They lend our deposits to companies, businesses, and individuals. Its the loan off-take that decides the income earned by banks.

When Banks cant Lend Enough: When companies don’t take enough loans, banks have excess cash. Bank deposit rates come down as banks cut down on their expenses. Your bank must have reduced the deposit rates by 0.50-1% in past few months. 

Companies are inclined to take less loans when their business is not growing. This is in turn is reflected in  the slow growth of economy as measured by gross domestic product (GDP. its the growth in the amount of income generated in the country through manufacturing, services etc). From about 8-9% in a quarter in 2011, GDP growth came down to 5% in the september quarter of this year.

Expectations of Interest Rate Cut Rise: When a country’s growth slows down for a long period, everyone expects interest rates to come down, so that companies can borrow at cheaper rates, and grow in size and profits.

So everyone starts expecting the Reserve Bank of India to reduce key interest rates so that economic growth can go up. Stock prices also rise in the anticipation of a rate cut.

When Expectations are Met?

The banks were expecting RBI to cut interest rates by 0.25% only. However it obliged with a 0.50% rate cut as inflation (rate at which prices increase) has come down. Our grocery bills may not have come down but as per RBI’s benchmark figures.

Now don’t just expect your Equated monthly installments (EMI) on loans to come down that quickly as banks have already been doing that.