RBI governor Shaktikanta Das’s idea of a 10 basis points rate cut would be meaningless

A 10 basis points cut would hardly have any impact on the Indian market. Instead, RBI needs to consider bigger cuts to impact interest rates.

RBI Governor Shaktikanta Das | PTI Photo/Shashank Parade

Reserve Bank of India Governor Shaktikanta Das has proposed to his counterparts in other central banks that cutting rates by 10 basis points instead of 25 may be a better option for monetary policy makers.

If he also intends to bring this idea to the RBI’s MPC, then it would be a move in the wrong direction. India may, instead, need bigger rate cuts for them to impact interest rates in the economy.

A 25 basis points rate cut when interest rates are at, say, 2 per cent, is a rate cut of one-eighth or 12.5 per cent. The policy interest rate, or the repo rate in the Indian context, is reduced from 2 per cent per annum to 1.75 per cent per annum.

When this rate cut gets translated into lower lending rates, they have a significant impact on the interest costs for borrowers or lenders. If there is a well-functioning monetary policy transmission mechanism, and let’s say the rate cut is fully transmitted into lending rates, it reduces the interest costs by 12 per cent. Lower interest costs of 10-12 per cent can make certain unviable projects viable. A rate cut of this magnitude can have an impact on the economy.

On the other hand, a 25 basis points cut at a 7 per cent policy rate only takes it down to 6.75 — a drop of just 0.035 per cent, or less than even half of 1 per cent. India has been a country with high policy interest rates. So 25 basis points rate cuts in India are very, very small in terms of the total impact they have on interest payments. They are unlikely to shift the numbers on viability or otherwise of investment projects.

Further, in India, the transmission of a 25 basis points is sometimes zero. Recently we have seen some banks cutting their lending rates by 5 basis points when the MPC has cut interest rates by 25 basis points.

Instead of thinking about cutting the rate by 10 basis points, central banks may want to shift to thinking about a 10 per cent change in interest rates. For India, if the interest rate is 7, then it would mean cutting the rate by 70 basis points, or nearly three times the typical cut of 25 basis points.

When the RBI would cut rates by 25 basis points from 8 per cent, the change was so small that there would be very little impact on the market. Yet, instead of discussing whether the standard rate cut in India should be 50 or even 100 basis points — which would be equivalent to the 1/8th cut of the US Federal Reserve System from 2 per cent by 25 basis points — the RBI typically followed the US Fed’s norms.

This would mean that different central banks have different standard magnitudes of rate cut, rather than the 25 basis points, and that should depend on their long-term policy rate. This may, of course, be too complicated for markets in the beginning, habituated as they are to basis points cuts. But it is something that needs to be debated.

We must remember that has two problems, transmission and inflation.

1. At the end of it, we need transmission, so a 10 basis points rate-cut would be meaningless as there would be zero transmission.

2. RBI is inflation targeting: How much would a 10 basis points change impact inflation? Could the impact be measured? If no, then one shouldn’t do something where one can’t measure the result.

There is an error in our measurement and inflation itself has a spread, so a 10 basis points change won’t make any measurable impact.

Ila Patnaik is an economist and a professor at the National Institute of Public Finance and Policy.

Views expressed by the author are personal.