RBI Monetary Policy: Raghuram Rajan Leaves Interest Rates Unchanged

When Raghuram Rajan took charge as the Reserve Bank of India Governor in September 2013, he immediately raised the repo rate (the rate at which the central bank lends money to scheduled commercial banks) from 7.25 per cent to 7.5 per cent. He again raised the repo rate by 25 basis point in October. In January 2014, he hiked the interest rate once again to eight per cent. Rajan, who has the reputation of being an inflation hawk, left the repo rate intact for a year after the three consecutive raises, despite great opposition.

When the RBI governor finally the cut the repo rate by 25 basis points to 7.75 in January 2015, it was the first repo rate cut since May 2013. This reduction did not benefit home buyers much because commercial banks did not follow the RBI step. This prompted the RBI to cut the repo rate again in March this year by 25 basis points to 7.5 per cent, followed by a another 25 bps cut in June. In September, Rajan surprised market commentators and economists by slashing the repo rate by another 50 basis points, to 6.75 per cent. In the fifth bimonthly monetary policy review held today, the RBI governor kept the rates unchanged.

How will this impact home buyers?

In his policy speech, Rajan said that growth in the construction industry had been sluggish because of slow activity. Consumption of construction material like steel also declined. Rajan said that because of the government's decision to investment in rail, roads and ports and RBI's decision to lower regulatory capital charges on low-income housing loans, construction sector was likely to soon perform better.

When the RBI cuts the repo rate, the cost of borrowing declines for Indian commercial banks. Commercial banks, in turn, transfer the rate cut to in the form of lower home loan interest rates, and by lower interest rates in general. For example, before the RBI cut the repo rate in January 2015, the base rate of Indian banks was in the range of 10 to 10.25 per cent. But, after the RBI cut the repo rate by 125 basis points, the base rate of banks fell into the range of 9.3 to 9.35 per cent

However, as the repo rate remains unchanged, home loan interest rates are not likely to fall any soon. The RBI may cut interest rates in 2016, after the December monetary policy review of the US Federal Reserve. The Fed had not tinkered with interest rates for almost a decade, since 2006. It was expected to cut the interest rates in September but Chairman Janet Yellen left interest rates unchanged.

One of the reasons why the RBI did not cut the repo rate further is that inflation rose moderately in October. In October 2015, retail inflation was at a four-month high of five per cent, attributed mainly to rise in food prices. The RBI said that it would cut interest rates further when inflation levels decline. The RBI had an informal target of four-six per cent, and now it is below it. But, Rajan has often pointed out that in developed countries with inflation targeting central banks, inflation is much lower. Home loan borrowers can expect a further cut when inflation in India falls to such levels.

The real change

It is often seen that the benefits of RBI reducing interest rates may not necessarily reach home buyers. The reason behind this is that when banks set interest rates, there is often a spread between the base rate and the interest rate at which they lend to borrowers, including home buyers.

For example, when SBI cut the repo rate from 9.75 per cent to 9.35 per cent in September this year, the home loan interest rates fell to 9.35 per cent only for the existing home loan borrowers. For others, the rate remained 9.55 per cent. The reason is that when SBI cut the base rate by 40 basis points, it also raised the spread from five basis points to 25 basis points, making the decline merely 20 basis points for new home loan borrowers. Similarly, when the ICICI bank cut the base rate from 9.70 per cent to 9.35 per cent by 35 basis points, it raised the spread by 10 basis points, leaving the benefit of a 25 basis points reduction in interest rates.