Sub-3.5% interest rate to shrink economy | Economic Times

Mumbai: 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. “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.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 capitalised, which relaxes their regulatory constraint and could clearly result in higher profitability. 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.