How low can interest rates go?: 

How low can interest rates go?: 

Context:

The interest rate on the one-year term deposit in India’s largest bank has nosedived from 9% in July 2014 to 6.5% now.  Interest rates on the three-year term deposit have dropped from 8.75% to 6.25%.

Introduction:

• In pegging down their deposit rates, banks have taken their cues from the Reserve Bank of India.
•  The RBI has pared its repo rate, the rate at which it lends overnight money to banks, from 8% three years ago to 6% now.
• Bank deposit rates dropping by a steep 250 basis points in three year

Trends in Indian interest rates over the last few years:

• The repo rate, which hovered at 9% in April 2001 drifted down to 6% by March 2004, but reversed direction to recapture the 9% peak in July 2008
• The global credit crisis hitting India and recessionary trends in the economy, RBI was forced to effect a swift and brutal reduction in rates again from 2008.
• This time around, the repo rate dropped from 9% in July 2008 to 4.75% by April 2009
• As growth limped back and inflation began rearing its head, the RBI embarked once again on a hiking spree, taking its rates from 4.75% in 2009 to 8% in 2012.
• The year 2012-14 saw a sideways crawl in rates.

Recent step:

• With inflation moderating the economy going into slow motion, RBI pruned its repo rate again, from 8% in 2014 to 6% by August 2017
•   In its recent policy reviews, RBI has shown reluctance to hack away from further, issuing warning about inflation risks.

Reasons for drop in rates:

•  Rates have dipped below 6% only under extra-ordinary circumstances, such as the global credit crisis.
•  India’s central bank prefers to prioritise inflation targeting over growth.

Variables considered:

The RBI considers other variables in its rate decisions:

•  The need to maintain positive real interest rates for savers. RBI officials have indicated that for savers to prefers financial instruments, it is desirable to maintain a real interest rate of anywhere between 1.25% and 2% above inflation.
•  The second variable that RBI considers is the inflation expectations of households for the future.

Present situation:

• Now, while recent inflation readings in India have been at the 2% mark, sustainable inflation rates are believed to be much higher.
• RBI’s own projections expect inflation rates of 3.5%-4.5% for the second half of this fiscal.
• Assuming a durable inflation rate of 4%, for savers to receive a 1.25%-2% real rates, policy rate need to be pegged at 5.25% to 6%.
•  RBI’s recent survey show that these expectations remain quite elevated despite the rock-bottom official inflation readings.
•  In the latest June survey, households perceived current inflation rates to be 6.4% and expected inflation one year ahead to be at 8.6%.