Monetary policy rates aren’t all that determine an economy’s credit scenario

So, as at the last MPC meet in August 2025, the policy repo rate, or the rate at which RBI pumps liquidity into the system, was kept unchanged at 5.5% while the monetary policy stance was retained at neutral.

This is not surprising. Speaking to a television channel about the MPC’s decision to maintain the status quo in August 2025, one of its members compared the committee’s predicament to that of a man sitting in a dark room, knowing there is a huge oil spill somewhere nearby; but not knowing where. In such a situation, he pointed out rightly that he is best off if he stays put and waits for some light to enter the room so that he doesn’t slip and fall.

The MPC seems to have done just that at its last meeting. Yet, in a world increasingly shaped by binaries—black and white, right and left—rather than different shades of grey, opinion on monetary policy was sharply divided in the run-up to the October meet of the MPC. Between those who saw rate action—a cut—as the only way forward and those who saw ‘no action,’ not to be confused with ‘inaction,’ as an equally plausible option.

The reality, however, is much more nuanced. Seasoned central bankers have long described central banking as an art rather than a science. Not only is there no one-to-one relationship between interest rates and macro-fundamentals such as inflation and growth, there is also no such relationship between the central bank’s policy rate and interest rates in the broader economy.

In the language of economists, the process of monetary transmission—whereby changes in policy rates impact broader interest rates in the economy and thereby growth and inflation—is not foolproof.

In the Indian context, monetary transmission invariably finds mention in RBI’s policy statements, usually with the air of an unstated excuse for why broader interest rates have not responded to its ‘diktat.’

The October policy statement is no different from the earlier ones in August, June and April this year. And Governor Sanjay Malhotra was extensively quizzed on this at the press conference that followed.

However, the policy rate is, at best, only a signalling mechanism. It indicates the direction in which, in the central bank’s view, rates should move, given the state of the broader macro-economy, and the direction in which the central bank will nudge rates with the instruments at its command. The operative words being ‘nudge’ and ‘instruments at its command.’

In the Indian context, these instruments include the repo rate, or the rate at which RBI pumps in liquidity, open market and foreign exchange operations that influence liquidity, the cash reserve ratio (CRR), which determines how much of bank deposits are impounded by RBI, macroprudential norms such as risk weights and, of course, the ultimate refuge of all central banks in emerging markets, ‘open mouth operations’ (discreet calls to a few bank heads to do as bid).

The problem is, despite a plethora of instruments, RBI’s ability to nudge, let alone control, market interest rates is limited.

Consider this. Since February, RBI has lowered the repo rate by 100 basis points and is in the process of cutting the CRR (in phases) by 100 basis points. In response, not only have bond yields risen—from 6.4% on 25 August to 6.59% on Wednesday—commercial banks, the main transmission channel, have also not reduced their rates commensurately. On the contrary, rate cuts have been passed on partially and asymmetrically between deposits and loan rates.

But RBI can take heart. It is not the only central bank to find itself on the losing side when pitted against markets. In the US too, bond yields rose from 4.01% in early September to 4.18% after the Federal Reserve’s rate cut on 17 September 2025. There are a number of reasons for this, including heightened geopolitical uncertainty, fear of higher government deficits and, by extension, of higher borrowing.

The point is, policy interest rates are just one determinant but not the only one of market interest rates. Wise central banks know this. It may be tempting to hold up ‘monetary transmission’ as the fall guy, portraying it as the reason why their rate actions are not followed better by markets. But signals, whether from RBI’s MPC or the Fed are just those—something that markets may choose to heed or disregard depending on how much credibility they carry.

Sadly for central banks, the world today is very different from 1992, when former European Commission president Jacques Delors could claim, “Not all Germans believe in God, but they all believe in the Bundesbank.” Today, central banks, RBI included, must accept they have feet of clay. Rate action is no silver bullet. Likewise, inaction is no cause for despair.

The author is a senior journalist and a former central banker.