How the repo rate works, and why it reaches your loan EMI

The rate is set by the Monetary Policy Committee, which has six members: three from the RBI, including the Governor, who chairs it, and three outside experts appointed by the central government. By law it must meet at least four times a year, and in practice the RBI publishes a calendar of meetings. Decisions are taken by majority vote, and the Governor has a casting vote if the committee is evenly split. The minutes are published afterwards, which is why headlines sometimes report a split vote.

The committee works to an inflation target set by the government, 4 per cent with a tolerance band of 2 to 6 per cent. A cut in the repo rate is more likely when inflation is comfortably inside the band and growth needs support; a rise, or a pause, is more likely when prices are rising faster than the target.

The RBI manages the day-to-day supply of money in the banking system, called liquidity, through a corridor of rates. The repo rate sits in the middle. Below it is the Standing Deposit Facility rate, the rate at which banks can park surplus money with the RBI. Above it is the Marginal Standing Facility rate, the price at which banks can borrow overnight in an emergency. The gap on each side has usually been 0.25 percentage points.

A bank that is short of cash for a night will not accept a rate far above the corridor, and one with spare cash will not lend below its floor, so overnight money-market rates stay close to the repo rate. Everything else is priced off those short-term rates.

Since October 2019, banks have had to link new floating-rate home, car and small-business loans to an external benchmark, and many use the repo rate. Such loans are priced as the benchmark plus a fixed spread, and the rate must be reset at least once every three months. A change in the repo rate therefore reaches most new borrowers quickly.

As an illustration, take a ₹50 lakh home loan for 20 years. At 8.5 per cent the monthly instalment is about ₹43,400. If the rate falls by 0.25 percentage points to 8.25 per cent, the instalment falls to about ₹42,600, a saving of roughly ₹800 a month. Many borrowers choose to keep paying the old amount, which shortens the loan instead.

₹50,00,000 for 20 years
8.50% a year  ->  about ₹43,400 a month
8.25% a year  ->  about ₹42,600 a month
Difference     ->  roughly ₹800 a month

Fixed deposit rates follow the repo rate too, but more slowly and not one for one, because banks adjust them according to how much money they need to raise. Government bond yields react almost at once, and often move in advance, when investors expect a change. The rate can also affect the rupee: higher rates in India relative to the rest of the world make rupee assets more attractive to foreign investors, other things being equal.

None of this is automatic. The effect of a rate change takes months to work through to prices and growth, which is why central banks try to act on where inflation is heading, not on where it is today.

A basis point is one hundredth of a percentage point, so a cut of 25 basis points is a cut of 0.25 points, from 6.50 per cent to 6.25 per cent, for example. Status quo means no change. The stance is the committee's signal about direction: accommodative leans towards lower rates, neutral keeps both options open, and withdrawal of accommodation leans towards tightening.

Look also at what the committee says about its inflation and growth forecasts, because the next decision depends on them more than on the last one.

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