RBI Cuts Repo Rate by 50 Basis Points Imapct on Interest Rates and EMIs
Falsifying all guesses from experts, RBI has declared a reduction in repo rate by 50 basis points. This means that the repo rate will now be 6.75% instead of 7.25%. This reduction has come because of US Federal Reserve’s status quo as well as low inflation, which allowed enough room to RBI to go for this drastic drop. Now that the short term lending rate has dropped, what is going to happen next?
Just in case you are not aware of what repo rate really means, it is actually the interest rate at which Reserve Bank of India lends money to commercial banks. Depending on the rate of borrowing, the commercial banks then set their lending rates for loans.
Reduction in repo rate was expected because of low inflation and of course sluggish economic growth. A reduced repo rate will help to roll more money into the economy, thereby providing the much needed boost to improve the economic growth.
There are a number of things that can happen now but most importantly, with the repo rate down, the banks will resort to more aggressive lending practices but that’s going to take some time. However, when it all starts, i.e. when the banks lower their lending rates, here are two things that will happen:
- There will be an increase in borrowing. More and more consumers will look for new loans at revised rates.
- Among the existing loan customers of banks, those on floating rates will be benefited because their monthly interest payments will drop. However, those on fixed interest rates will suffer because they will continue to pay at higher interest rates.
Talking about new borrowers, what should they opt for – floating or fixed rates?
It is to note that inflation is at its historic low of 3.66%. There will be market corrections. Interest rates will increase. This will happen because with reduced repo rate, there will be more money with banks to spare. This will increase money supply in the economy. As money supply increases, demand for goods and services grow, which pushes the economy further and leads to increase in the overall interest rate. Thus, market correction is on its way.
Topping this, with decrease in repo rate, not just the lending rates fall, there will also be a fall in interest rates for fixed deposits, savings accounts etc. This is when, people will deposit less. This further increase the money supply in the economy.
Now, in case if new borrowers, it will be beneficial to go for fixed interest rates. As interest rates move up in future, those with floating interest rates will be the ones to lose out.
Are there any other reasons for interest rates to go up?
It is not just the internal mechanism of the economy that will lead to increase in interest rates. RBI’s current decision to lower repo rates was partly based on status quo of US Federal Reserve. US economy is in a terrible shape. Feds have not increase their lending rates from near zero in last 9 years and they haven’t done it this September as well. So, it is very likely that they will do so early next year and stop the huge monetary stimulus they provided to the US economy.
When that happens, US economy will accumulate more debt (which is already standing at $18+ trillion). To deal with this, US will increase its taxes and at the same time, increase international lending rates.
International borrowers will then have to increase their own interest rates to deal with the loans they take from US. This will trigger a series of inflationary jump. India will not be immune to such domestic and international monetary policies of US.
Will decrease in repo rate lead to instability in Indian economy?
We cannot say that for now but if we look at the US economy and travel back in time to 2007-2009 period of US recession, we need to remind ourselves that the recession was created by a housing bubble because of unprecedented subprime lending. Banks gave out loans and the housing bubble kept on increasing until it eventually burst. The result was economic recession and a chain of foreclosures unlike anything ever seen before.
If Indian banks reduce the lending rates (again, this is not going to happen anytime soon), India will also experience housing bubble (at least to some extent). People will be lured into borrowing more money but eventually when the interest rate grows, default rates will start growing. This is not a good sign.
How soon this will happen will definitely depend on how soon Indian banks decrease their lending rates and how soon US Fed decides to normalize US economy by increasing interest rates and suppressing the monetary stimulus.
Should you borrow?
Okay, this is a bad question because you need to understand your requirements. More money is always good but more money that is not owned by you is not good. So, if you are borrowing more and more, you will have to eventually pay it back. Do you have the necessary financial backup to repay your borrowings? This is something you need to determine because one miscalculation will send you spiraling down from where declaring bankruptcy will be the only way out. If you do so, i.e. declare bankruptcy, you will completely destroy your credit ratings. No one wants that to happen.
Conclusion: RBI’s decision to cut down on repo rate looks normal when we look at low inflation and sluggish economic growth but its decision to base its decision on US Federal Bank’s decision is something not very acceptable. Fed is going to focus on domestic needs and hence, RBI should have done the same. US headed for catastrophic economic collapse and it will only take a miracle to save her. RBI shouldn’t have used US Fed’s decision as its own decision-making parameter.
Impact of Rate Cut on Interest Rates, EMIs and FDs
It is clear now that your current EMIs will come down. New loans will be cheaper there will be more money in your pocket to spend. This seem to be a good news but the con of this news is that if interest rates of FD will come down. So if you were planning to make some FDs of your savings then this may be a bad news for you. We have already seen interest Rates on FDs have come down sharply in recent months.