Transmission: from the repo rate to the real economy

Detail

1. The benchmark rate: where transmission starts

• Benchmark interest rate: the reference rate that other interest rates are linked to. When it moves, the others are expected to move too.
• In India the benchmark is the RBI's policy repo rate. This is the interest rate at which the RBI lends money to banks for a short time (overnight to a few days), against government securities that the bank pledges.
• Class 7 NCERT calls it "the base interest rate that the RBI fixes for lending money to commercial banks".

• Trap: this is not the "Base Rate" lending system that banks used from 2010 to 2016. That was a bank's own minimum lending rate, not an RBI rate.

• The policy corridor (the band that keeps overnight rates close to the repo rate), as of 2026 [4][5]:

• Repo rate: 5.25% (unchanged at the April, June and August 2026 meetings).
• SDF rate (Standing Deposit Facility, the rate the RBI pays when banks park extra cash with it): 5.00%. This is the floor.
• MSF rate (Marginal Standing Facility, the emergency borrowing rate for banks) and Bank Rate: 5.50%. This is the ceiling.

• The stance is neutral. The August 2026 meeting (the 62nd MPC meeting, 3-5 August) kept the rate on a unanimous vote [5].

• Recent path of the repo rate:

• It rose by 250 basis points in the tightening cycle that began in May 2022, taking it to 6.50% [2]. (1 basis point = 0.01 percentage point, so 100 bps = 1%.)
• The RBI then started cutting. The April 2025 cut of 25 bps brought it to 6.00% [6].
• It stood at 5.25% by April 2026 [4]. That is a total cut of 125 bps from 6.50%.

2. Monetary policy transmission: the stages

• Monetary policy transmission: the process by which a change in the policy rate passes through to other interest rates, then to spending, and finally to output and inflation.
• The chain, stage by stage:
• Stage 1: the money market (very short-term borrowing between banks and other institutions). A repo change first moves:
  • WACR (Weighted Average Call Rate, the average rate on overnight loans between banks; this is the RBI's operating target)
  • TREPS (Tri-party Repo, overnight collateralised lending, settled through CCIL)
  • market repo
• Stage 2: short and long bonds. These rates then move:
  • T-bill yields (Treasury bills, short-term government debt of up to 1 year)
  • CP/CD rates (Commercial Paper issued by companies; Certificates of Deposit issued by banks)
  • G-sec yields (dated government securities)
• Stage 3: bank rates. Then bank deposit and loan rates move:
  • WADTDR (Weighted Average Domestic Term Deposit Rate, the average rate banks pay on fixed deposits)
  • WALR (Weighted Average Lending Rate, the average rate banks charge on loans). Each is measured separately for fresh (new) and outstanding (all existing) deposits and loans.
• Stage 4: spending and asset prices. These rate changes affect:
  • consumption, through EMIs (Equated Monthly Instalments)
  • investment by firms
  • asset prices (shares, property)
  • the exchange rate, through foreign capital flowing in or out

• Stage 5: the final goals. Output (GDP) and inflation change.

• A worked example of a rate hike:

• Repo up by 50 bps → overnight rates (WACR) go up the same day.
• After weeks: T-bill and CD rates rise → banks raise their fixed deposit and loan rates.
• After months: home and car loans cost more → people buy less → demand cools → prices rise more slowly.

3. Lags: how long each stage takes

• Transmission lag: the time between a policy change and its effect.
• Rough estimate from the NCERT scaffold: about 2-3 quarters to output and 3-4 quarters to inflation. RBI studies give different numbers, so treat these as rough ranges. They were not checked against a current RBI source here.
• Research on emerging markets measures the effects over horizons of 1 to 12 quarters [7].
• Transmission depends on the state of the economy (IMF, 2026) [7]:
• Monetary policy has strong effects on output during recessions and after a period of loose policy.
• It has little effect during booms or when policy is already tight.

• The effect on prices is weak in both situations.

• Trend inflation also matters (IMF, 2023) [8]:

• When trend inflation is low, policy has a bigger effect on output and a smaller effect on prices.

• When trend inflation is high, the reverse holds: the output effect is small and the price effect is larger.

• This is why the RBI makes decisions using projections of future inflation, not today's figure. For example:

• CPI inflation was projected at 4.6% and real GDP growth at 6.9% for 2026-27 (April 2026) [4].
• The quarterly CPI path was 4.0% → 4.4% → 5.2% → 4.7% [4].

4. Channels of transmission

Channel	How it works (rate cut example)
Interest rate channel	Loans get cheaper → firms invest more, households take loans for houses and cars
Credit channel	Banks have cheaper funds and more cash to lend → they give more loans, especially to small firms that depend on banks
Asset price / wealth channel	Lower rates raise the prices of shares and bonds → people feel richer → they spend more
Exchange rate channel	Lower Indian rates → foreign investors take money out → the rupee weakens → exports get cheaper and imports costlier (imported inflation)
Expectations channel	People and firms believe the RBI will keep inflation low → they ask for smaller wage and price increases

• Worked example: EMI (interest rate channel)
• Formula: EMI = P × r × (1+r)ⁿ / [(1+r)ⁿ − 1]
  • P = loan amount
  • r = monthly interest rate (annual rate ÷ 12)
  • n = number of months
• Home loan of ₹30 lakh for 20 years (n = 240):
  • at 9.0%: EMI ≈ ₹26,992
  • at 8.5% (after a 50 bps cut is fully passed on): EMI ≈ ₹26,035
• The borrower saves about ₹957 a month, which is money they can spend on other things. This is how a rate cut raises consumption.

5. How to measure transmission, and India's record

• Formula: Pass-through (%) = (Change in lending or deposit rate ÷ Change in repo rate) × 100
• The 2022-23 tightening cycle (repo up 250 bps from May 2022; bank rates measured May 2022 to September 2023) [2]:
• WALR on fresh loans: +187 bps. Pass-through = 187 ÷ 250 × 100 = 75%.
• WALR on outstanding loans: +111 bps, only 44%. Old loans reprice slowly.
• 1-year MCLR: +152 bps.

• WADTDR on fresh bulk deposits: +269 bps. Fresh retail deposits rose +164 bps and outstanding deposits +166 bps.

• Long-run pass-through (RBI econometric estimate) [2]:

• 69 bps for every 100 bps repo change over the full sample.
• 82 bps in the EBLR period (2019 Q3 to 2022 Q4).
• Pass-through is stronger when rates are rising than when they are falling.

6. Why transmission is slow and partial in India

• Fixed-rate term deposits dominate what banks owe:
• Most bank funds come from fixed deposits at rates promised for 1-5 years.
• When the repo rate falls, the bank still pays the old high rate on these deposits.

• So its cost of funds (what the bank pays for the money it lends) falls slowly, and it cannot cut loan rates quickly.

• Administered small-savings rates:

• The government, not the market, sets rates on PPF, NSC, post office deposits and similar schemes. It revises them quarterly.
• If a bank cuts its deposit rate below these, savers move their money to small savings.

• So banks cannot freely cut deposit rates, and in turn cannot cut loan rates.

• CRR/SLR pre-emptions lock up part of bank funds:

• CRR (Cash Reserve Ratio) is cash kept with the RBI on which the bank earns no interest.
• SLR (Statutory Liquidity Ratio) is money that must be held in government securities and similar safe assets.

• Money locked up here cannot be lent, which raises the effective cost of the funds that are lent.

• Stressed balance sheets (NPAs):

• NPA (Non-Performing Asset) means a loan on which interest or principal is unpaid for more than 90 days.

• Banks with high NPAs keep loan rates high to cover losses, and they lend cautiously even when the RBI cuts rates.

• Heavy government borrowing:

• A large fiscal deficit means the government borrows a lot → it competes with firms for savings → G-sec yields stay high → all long-term rates stay high.

• Informal lenders (moneylenders, traders, landlords) are outside the RBI's reach:

• Class 10 NCERT notes that "there is no organisation which supervises" these credit activities.

• Their rates do not follow the repo rate, so rural and poor borrowers see little effect.

• Uneven use of external benchmarks. Share of floating-rate loans linked to an external benchmark, June 2023 [2]:

• foreign banks: 87.6%
• private banks: 73.2%
• public sector banks: only 36.1%
• So a large share of public sector bank loans still followed slower internal benchmarks (MCLR).

7. Fixes: the evolution of lending benchmarks

• BPLR (Benchmark Prime Lending Rate) → Base Rate (2010) → MCLR (Marginal Cost of Funds based Lending Rate, 2016) → External Benchmark Lending Rate (EBLR) (October 2019).
• Why each change happened: the earlier benchmarks were set by banks themselves from their own cost of funds. Banks could delay passing on rate cuts.
• EBLR:
• It was made compulsory from 1 October 2019 for new floating-rate loans to certain categories: retail borrowers (home, auto, personal) and MSMEs.
• The aim was that loan rates should no longer depend on how fast banks adjust their deposit rates [2].
• Most banks chose the policy repo rate as their external benchmark [2].

• Worked example: loan rate = repo rate + a spread fixed by the bank. With repo at 5.25% and a spread of 2.75%, the loan rate is 8.00%. If repo falls by 25 bps, the loan rate falls to 7.75% at the next reset (reset at least once every 3 months).

• Further details → banking-regulation-npas.

8. Forward guidance: working through expectations

• Forward guidance: the central bank tells markets how it is likely to set policy in the future. This shapes expectations today, so longer-term rates (G-secs, corporate bonds) move before the RBI actually acts.
• Time-based guidance (tied to a period of time):
• RBI, October 2020: it would stay accommodative "at least during the current financial year and into the next".

• US Fed: rates would stay low for an "extended period".

• State-based guidance (tied to conditions being met): for example, "rates will stay low until inflation is durably at target".

• Why it works: if a central bank that people trust promises to keep rates lower for longer, this gives extra stimulus and brings inflation back to target faster [9].
• Mario Draghi's "whatever it takes" (ECB, 2012) calmed euro-area bond markets mainly through expectations, even before any large bond buying took place.
• Other communication tools:
• the MPC resolution and statement
• minutes published 14 days after each meeting (e.g. the August 2026 meeting's minutes on 19 August 2026) [5]
• the stance (accommodative / neutral / withdrawal of accommodation)
• the Monetary Policy Report, published twice a year
• the date of the next meeting, announced in advance (next: 5-7 October 2026) [5]

Prelims Hooks

• India's benchmark policy rate is the repo rate. It is not the 2010-16 bank "Base Rate". (Class 7 calls the repo rate the "base interest rate".)
• The operating target of RBI monetary policy is the WACR (overnight call money rate), not the repo rate itself.
• Corridor in 2026: SDF 5.00% (floor) < Repo 5.25% < MSF = Bank Rate 5.50% (ceiling) [4][5].
• WALR = Weighted Average Lending Rate; WADTDR = Weighted Average Domestic Term Deposit Rate. Both are published separately for fresh and outstanding amounts.
• Order of lending benchmarks: BPLR → Base Rate (2010) → MCLR (2016) → EBLR (1 Oct 2019).
• In 2022-23, pass-through to fresh loans (75%) was much higher than to outstanding loans (44%) [2].
• Transmission is stronger in tightening than in easing phases [2].
• EBLR share of floating loans (June 2023): lowest in public sector banks (36.1%) [2].
• Time-based guidance: RBI October 2020, "at least during the current financial year and into the next". State-based guidance: linked to conditions being met.
• Informal lenders are outside RBI supervision (Class 10), so they are a gap in transmission.

Mains Points

• Deposit-side rigidity is the core problem:
• Fixed-rate deposits and administered small-savings rates slow down the fall in banks' cost of funds.

• EBLR fixed the loan side, but banks then face pressure on their net interest margins (the gap between what they earn on loans and pay on deposits). This is a trade-off between faster transmission and bank profitability.

• Fiscal and monetary policy are linked:

• Heavy government borrowing keeps G-sec yields high and weakens rate cuts.

• Keeping to the fiscal deficit path and aligning small-savings rates with market rates would make RBI action more effective.

• Transmission depends on the state of the economy [7][8]:

• Cuts help more in downturns, and hikes hurt prices less when inflation expectations are firmly anchored.

• This argues for acting early, using projections, together with credible communication through forward guidance, MPC minutes and a clear stance.

• Financial inclusion is itself a transmission issue:

• Borrowers who depend on moneylenders are untouched by the repo rate.
• Formal credit (SHGs, MUDRA, priority sector lending) widens monetary policy's reach, alongside the Class 10 argument that formal credit is fairer.