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Rate cuts beyond a point could be counter-productive: Report


Policy rates cannot dip below a threshold, beyond which a rate cut could be counter-productive and lead to an economic contraction rather than stimulating it, according to a research report by SBI economists.

They further said that lowering policy rates below 3.5% could be counterproductive and recommended an activist fiscal policy going forward.

The report referred to a 2018 research paper by the US-based non-profit National Bureau of Economic Research (NBER), according to which a lower bound is given by the “reversal interest rate”, the rate at which accommodative monetary policy reverses its effect and becomes contractionary for output.

If the central bank reduces the policy rate below such a “reversal interest rate”, the monetary policy rate depresses rather than stimulates the economy.

In the Indian context, the SBI economists analysed banking sector data over a 15-year period, looking at the net interest income and capital gains.

They said a cut in the policy rate benefits banks that have long-term legacy assets with fixed interest payments. As the central bank lowers the policy rate, banks can refinance their long-term assets at a cheaper rate. This increases the value of their equity; they are better capitalized, which relaxes their regulatory constraint and could clearly result in higher profitability and is termed as capital gains impact on bank profitability and works inversely to changes in the policy rate.

However, a lower policy rate also negatively impacts banks’ profits on new business, by lowering their net interest margins.

Assuming perfectly competitive financial markets, a policy rate cut should be over time passed through to loan rates and deposit rates.

This is called net interest margin impact on bank profitability that works directly in tune with changes to the policy rate.

Hence, the net impact on bank profitability can work in any direction, and therefore the concept of “reversal interest rate” — the rate at which the risk-taking ability of banks by higher lending through lower rates is just adequate to cover their net worth.

Any further rate cuts beyond this threshold results in banks cutting back on lending and being forced to increase their safe asset holdings.

SBI economists estimate
that a “reversal” repo rate below 3.5% will be detrimental for lending and also suggest that one-year deposits cannot fall by more than 25 basis points from the threshold.

“We believe any further rate cuts will have the unintended impact on the economy. Instead, we strongly recommend for India an activist fiscal policy. Research shows that fiscal multipliers are always larger when monetary policy is at the lower bound as investors anticipate a prolonged period of low interest rates,” according to the report.

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