Analysis. Monetary Policy: Waiting and watching for the lag effect to kick in

The RBI keeping the key repo rate unchanged in Tuesday’s policy review tempered the recent euphoria in equity and bond markets. After its surprise 25 basis points repo rate cut just over a fortnight back, the RBI is now awaiting fiscal developments in the Budget and sustainability of falling retail inflation before stepping up its rate cut.

But borrowers can still find comfort from the fact there is a clear scope for a 25-50 basis point rate cut over the next couple of months, given the RBI’s real risk-free rate target of 1.5-2 per cent. If retail inflation tends towards 5.25-5.5 per cent by the end of 2015-16, the RBI is likely to lower its repo rate to 7 per cent in the next two-three quarters. However, a cut in lending rates for borrowers will happen in fits and starts.

The lag Transmission of the RBI’s policy actions takes place with a lag. After the RBI’s surprise rate cut in January, only three banks reduced their base rates — to which all lending rates are benchmarked. Others are still dragging their feet, despite having reduced their deposit rates over the last couple of months.

With credit growth slipping to 10 per cent in December 2014, banks have been finding it hard to keep their margins intact. Hence, they are likely to make the most of lower cost of borrowings to shore up margins than pass it on to borrowers in the form of lower lending rates.

Increasing risk in the system also limits the pass through of policy action. One, banks are already earning lesser income on assets, given the increase in stressed assets. Two, banks yearn for a higher spread to compensate for the risk. Hence, pick up in credit growth and easing of stress will hold the key to transmission.

By reducing the total SLR requirement, , the RBI has gone a step further to align interest rates across different segments to market-determined rates. The objective is to facilitate the transmission of rates across segments.

In the past, there has been a ready market for bond buybacks by the RBI through open market operations as well as through the SLR mandate. This has kept rates on government borrowing suppressed. By doing away with a captive market for government securities, the RBI is seeking to realign the cost of borrowing to market-determined rates. The total SLR requirement for banks has been reduced by 50 basis points to 21.5 per cent of deposits. This will free up close to ₹45,000 crore of banks’ funds to lend to productive sectors.

But given the lack of viable lending opportunity and perceived risk, banks are likely to carry excess investments until growth in the economy picks up.