Your Money: Interest Rates — We Are In A Neutral Zone Now 

So far, the RBI has been on a rate reduction cycle. Gradually, as economic recovery gains traction, the RBI will change stance as it moves towards normalization of rates.

To get a perspective on the interest rate structure that is prevailing currently, let’s start by looking at RBI repo rate, the rate at which RBI would lend money to banks for one day. That rate is 4%, and is at an all-time low. The significance of repo rate is that this is the needle that moves the interest rate structure across the entire market and economy. However, currently, the effective rate is the reverse repo rate of 3.35%, much lower than the repo rate of 4%.

This is due to the phenomenon of banking system liquidity surplus; banks are rather parking money with the RBI at 3.35% than availing at 4%. So what does this mean for you and me? The interest rate structure in the economy is on the lower side. Bank deposit rates are lower than earlier.

Home loan rates, as per the advertisements, are screaming at a low of 6.5%. To be noted, 6.5% is on floating rate, which would move up as and when the RBI hikes repo rate. The fixed rate loans are at a much higher rate.

Small savings rates, popularly known as Post Office rates, are fixed by the government, and reviewed every quarter, as per a formula. The formula is, government security yields (traded interest rate levels) in the secondary market plus a spread; i.e., mark-up. As an example, the spread on Senior Citizens Savings Scheme will be 100 bps over comparable maturity G-Secs (100 bps equal 1%). The rationale for linking it to G-Sec yields in the secondary market is that it is in line with interest rate movements; G-Sec yield movements reflect the actual and anticipated events in the economy pertaining to rate movement.

However, the rates fixed by the government on the quarterly reviews are higher than warranted by the formula of G-Sec yield plus defined spread. The higher small savings rates are beneficial to the populace. But there is a flip side to it. As long as the RBI was bringing down interest rates to make cheap money available to pump the economy, to fight the pandemic-induced slowdown, it was counter-intuitive.

On March 31, 2021, small savings rates were reduced drastically through a notification, only to be withdrawn the next day. Erstwhile rates were maintained. Due to this drama, there was an expectation that rates may be reduced in the next review on June 30. Rates were maintained, and were maintained recently on September 30 as well. As an example, today, the rate on NSC VIII Issue, which is a 5-year scheme, is 6.8% and that on a 5-year time deposit is 6.7%.

View forward
So far, the RBI has been on a rate reduction cycle. As economic recovery gains traction, the RBI will change stance. Since small savings rates were maintained in the reduction cycle, it is likely, now that we are in a neutral zone, rates will be maintained going forward. As of today, the corridor is wide between 3.35% and 6.8%, even after giving something for time value of money between one day and five years, as per historical standards. This is lop-sided from the macro perspective, but beneficial for savers, particularly middle / lower-middle income people in rural areas.


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