The RBI governor Raghuram Rajan’s move to cut the key policy rate - the repo - by 25 basis points to 7.25 per cent on Tuesday was in line with expectations. But it failed to cheer markets. This is because the central bank has hinted that rate cuts for are done with for now; further cuts will be contingent on how inflation pans out. Sub-par monsoons, firming oil prices and a volatile external environment can mean higher inflation. The RBI now sees upside risks to its January 2016 inflation forecast of 6 per cent.

With limited policy action expected over the next couple of months, across-the-board cuts in lending rates by banks are unlikely.

Mind the lag

While the RBI’s move on Tuesday will set the direction for banks to reduce interest rates, the full transmission of this to borrowers will come with a lag and selectively across banks - as it has been in the past.

It took two rate cuts since January and a rap on the knuckles by the RBI governor for banks to finally start reducing their base rates - to which all lending rates are pegged. Many banks have lowered their benchmark base rates by 15-25 basis points since the April policy. While banks have reduced their deposit rates by about 50 basis points across tenure, they have not passed on the benefit entirely to borrowers. This is because the base rates are determined by each bank based on their cost of funds, administrative costs and profitability. Banks also source only a small portion of their funds from the repo window.

Given the poor performance of banks, especially the public sector ones in the recent March quarter, lending rate cuts will stress margins even more. With stressed assets at over 10 per cent of loans, most public sector banks are already earning lesser income on assets. Hence banks will look hard before they leap on their rate cuts.

The RBI’s cautious stance on further cuts will also limit banks’ rate action. After the recent cuts, base rates of most banks are at 10 per cent while the lowest is at 9.75 per cent. There could be another 15-25 basis points cut in base rates, but gradually and on a case to case basis.

Limited room for bond rally

The bond market which has rallied over the last year, first on expectations of a rate cut, then on RBI’s two policy rate cuts since January, may be in for a pause. After the RBI’s rate cut on Tuesday, the yield on the 10-year government bond has risen marginally to about 7.7 per cent. Given that the chunk of the rate cut --75 basis points—has happened now, the market is likely to temper its expectations.

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