How low can interest rates go?

If you’re a retiree subsisting on income from bank deposits, you’re probably dismayed by the ‘bungee-jump’ in interest rates.

The interest rate on the one-year term deposit in India’s largest bank has nosedived from 9% in July 2014 to 6.5% now. Interest rates on the three-year term deposit have dropped from 8.75% to 6.25%.

In pegging down their deposit rates, banks have taken their cues from the RBI. The central bank has pared its repo rate, the rate at which it lends overnight money to banks, from 8% three years ago to 6% now.

How far?

So, with bank deposit rates dropping by a steep 250 basis points in three years (50 basis points more than the repo rate), how much further can they fall? And will they rebound at all?

History suggests that we may be quite close to the bottom of this falling rate cycle.

Looking back at trends in Indian interest rates over the last fifteen years suggests that the debt markets, just like the stock markets, go through cycles.

The repo rate, which hovered at 9% in April 2001 drifted down to 6% by March 2004, but reversed direction to recapture the 9%peak in July 2008. But, with the global credit crisis hitting India and recessionary trends in the economy, RBI was forced to effect a swift and brutal reduction in rates again from 2008. This time around, the repo rate dropped from 9% in July 2008 to 4.75% by April 2009.

As growth limped back and inflation began rearing its head, the RBI embarked once again on a hiking spree, taking its rates from 4.75% in 2009 to 8% in 2012. The years 2012 to 2014 saw a sideways crawl in rates. But with inflation moderating and the economy going into slow motion, RBI pruned its repo rate again, from 8% in 2014 to 6% by August 2017. In its recent policy reviews, RBI has shown reluctance to hack away any further, issuing warnings about inflation risks.

Predictable band

This brief history of interest rates tells us two things. One, benchmark interest rates have broadly gyrated in a band of 6%-9% in the last fifteen years. When the rate sinks to the lower end of the band, circumstances conspire to flag off the next rate hike cycle.

Rates have dipped below 6% only under extra-ordinary circumstances, such as the global credit crisis. When they do, they have seldom stayed there for good. In 2004-05, the policy rate stayed at 6% for 18 months before the uptrend started. In 2009-10, it stayed below 6% for 15 months before a turnaround.

Two, India’s central bank prefers to prioritise inflation targeting over growth. It is usually prompt with pre-emptive rate hikes to quell inflation, but doesn’t hurry to cut rates in a downturn.

Two years ago, RBI’s role as an inflation warrior was further cemented by the Monetary Policy Agreement it has inked with the Centre. The Agreement specifically tasks RBI with ensuring that retail inflation stays within the 2%-6% band. With this new framework in place, RBI is likely to maintain an even closer vigil on inflation and undertake rate cuts even more sparingly than before.

This is probably why, despite consumer price inflation dipping below its 4% target a good eight months ago, RBI held off further rate cuts for almost ten months until it acted this month.

Variables considered

But is not just history which suggest that rates could be close to their low point in this cycle.

Other variables hint at it too. Current inflation rates apart, the central bank considers two other variables in its rate decisions.

The first is the need to maintain positive real interest rates for savers. RBI officials have indicated that for savers to prefer financial instruments, it is desirable to maintain a real interest rate of anywhere between 1.25% and 2% above inflation.

Now, while recent inflation readings in India have been at the 2% mark, sustainable inflation rates are believed to be much higher. RBI’s own projections expect inflation rates of 3.5%-4.5% for the second half of this fiscal.

Assuming a durable inflation rate of 4%, for savers to receive a 1.25%-2% real rates, policy rates need to be pegged at 5.25% to 6%. At worst, therefore, depending on the inflation trajectory, this allows room for the repo rate to dip by 75 basis points from here.

But remember that bank deposit rates have already been cut by 50 basis points more than repo rates and so have only very limited room to fall further.

The second variable that RBI considers is the inflation expectations of households for the future. RBI’s recent surveys show that these expectations remain quite elevated despite the rock-bottom official inflation readings. In the latest June survey, households perceived current inflation rates to be 6.4% and expected inflation one year ahead to be at 8.6%. Unless those expectations fall sharply, this puts a floor to rate cuts too.

If you’re a bank depositor, all this number-crunching suggests two courses of action. Don’t despair, as bank deposit rates may not fall too much from here. And as there’s a live possibility of rates rising again, once they complete their bungee jump, it is best not to lock into these rock-bottom rates for more than a year.