Context: RBI’s Monetary Policy Committee (MPC) is expected to cut the repo rate by 25 basis points (bps) in its upcoming meeting (February 2025), from 6.5 per cent to 6.25 per cent.
If implemented, this would be the first rate cut in nearly five years. This decision is influenced by easing inflation, government stimulus measures, and the need to boost economic growth.
Relevance of the Topic:Prelims: Repo Rate, External benchmark lending rate, Marginal cost of fund-based lending rate; RBI’s Inflation targeting framework
Repo Rate:
- Repo rate is the interest rate at which the commercial banks borrow money from the Reserve Bank of India (RBI) during a short-term liquidity crunch.
- Repo stands for ‘Repurchasing Option’ or ‘Repurchase Agreement’.
- In the agreement, banks provide eligible securities such as Treasury Bills to the RBI, while availing overnight loans. They agree to repurchase securities at a predetermined price later from RBI.
- Thus, the bank gets the cash and the central bank the security.
How does Repo Rate affect the Economy?
- Rise in inflation:
- During high levels of inflation, RBI increases the repo rate to bring down the flow of money in the economy.
- This curbs excessive spending, makes borrowing costly for businesses and industries, slows down investment and money supply in the market, and eases inflation.
- Increasing Liquidity in the Market:
- When the RBI needs to pump funds into the economy, it lowers the repo rate. Consequently, businesses and industries find it cheaper to borrow money for different investment purposes.
- It also increases the overall supply of money in the economy. This ultimately boosts the growth rate of the economy.
Related Monetary Policy Tools:
1. Reverse Repo Rate:
- Reverse Repo Rate is when the RBI borrows money from banks when there is excess liquidity in the market.
- The banks benefit out of it by receiving interest for their holdings with the central bank.
- Reverse Repo Rate is a mechanism to absorb the liquidity in the market, thus restricting the borrowing power of investors.
- During high levels of inflation in the economy, the RBI increases the reverse repo.
- It encourages the banks to park more funds with RBI to earn higher returns on excess funds.
- Banks are left with lesser funds to extend loans and borrowings to consumers.
2. Marginal Cost of Lending Rate (MCLR):
- MCLR is the minimum interest rate at which commercial banks can lend.
- This rate is based on four components:
- Marginal cost of funds
- Negative carry on account of cash reserve ratio
- Operating costs
- Tenor premium
- MCLR is linked to the actual deposit rates. Hence, when deposit rates rise, it indicates the banks are likely to hike MCLR and lending rates are set to go up.
3. External Benchmarks Lending Rate:
- To ensure complete transparency and standardisation, RBI mandated the banks to adopt a uniform external benchmark within a loan category, effective from 1st October, 2019.
- Unlike MCLR which was internal system for each bank, RBI has offered banks the options to choose from 4 external benchmarking mechanisms:
- RBI repo rate
- 91-day T-bill yield
- 182-day T-bill yield
- Any other benchmark developed by Financial Benchmarks India Pvt. Ltd.
Factors influencing Repo Rate Cut Decision:
- Easing Inflation:
- Retail inflation fell to 5.22% in December 2024, the lowest in four months. Lower inflation allows for monetary easing without major inflationary risks.
- Union Budget 2025-26 stimulus:
- Tax cuts and revised TDS limits aim to boost disposable income and consumption.
- Increased consumer demand may require monetary support for sustained economic growth.
- Liquidity Measures by RBI: Recent liquidity enhancement steps of RBI ensure banking system liquidity before a rate cut. RBI announced liquidity enhancement measures such as:
- $5 billion forex swap.
- ₹60,000 crore open market operations.
- ₹50,000 crore variable repo rate operations.
- Global Economic Uncertainty:
- Trade tensions: US imposing tariffs on China, Canada, and Mexico, is creating instability in global trade.
- Impact on currency markets, with rupee hitting an all-time low of ₹87.29 per USD.
- The RBI must balance rupee stability and domestic liquidity management.
Impact of Repo Rate Cut on Economy
- Reduce Borrowing costs:
- Repo-linked lending rates (EBLR): A cut in repo rate will reduce borrowing costs, making home, vehicle, and business loans cheaper.
- MCLR-linked loans: Banks may also reduce rates for loans linked to the marginal cost of funds-based lending rate (MCLR). This will lead to lower lending rates for borrowers.
- The expected 25 bps rate cut will lower EMIs for borrowers.
- Boost Economic Growth: A rate cut could stimulate investment and consumption, boosting GDP.
The anticipated repo rate cut signals a pro-growth strategy while ensuring inflation remains in check.