Monetary Policy Transmission: Why Rate Cuts Take Time to Arrive

Transmission is the journey a rate change makes from the authority that announces it to the household that actually pays interest. The journey takes time because most of it runs through contracts that reset on their own schedule rather than on the authority's. And it is never complete: a large part of any cut simply does not arrive.

Most confusion about rate cuts comes from running three things together. Separate them before anything else. The announcement happens on a single day and is a fact about a committee. The arrival happens over months and is a fact about contracts. The amount shrinks along the way and is a fact about arithmetic. An account that gives only the announcement has given the smallest of the three.

The groundwork for this is already settled. What a policy rateThe single rate an authority sets and announces, and against which shorter borrowing between banks is priced. How a policy rate is decided is covered separately. is, and what it is set against, is one part of that groundwork; what the toolkit contains and how operations move cash into and out of the banking system is another; and so is what the cycle is doing when a cut is announced. That condition is what the cut is answering. The leg nobody watches is the part between the announcement and somebody paying less on the fifth of the month.

What is monetary policy transmission, and what exactly is travelling?

Start with something that has nothing to do with banks. A wholesaler in a mandi drops the price of onions by ten rupees a kilo on a Monday morning. The question is when the woman buying two kilos for her kitchen on Thursday pays ten rupees less. She might. But between the wholesaler and her kitchen there is a commission agent working off yesterday's rate, a retailer who bought at the old price and still has that stock to clear, and a shop board that gets rewritten when somebody gets round to it. The cut was real on Monday. Whether it reached Thursday is a completely separate question, and it is answered by the contracts and the stock in between, not by the wholesaler.

Monetary policy transmission is that question asked about interest. An authority announces that the rate it controls is lower. Nothing in that announcement changes what anybody pays. The announcement changes the price at which the next round of contracts gets written, and those contracts get written at their own pace.

A rate does not travel down the chain; a repricing does, and a repricing can only happen at a moment when something is being priced again anyway. The chain has as many delays as it has links. Look at the chain itself. The authority moves the rate it controls. The money marketThe place where banks and other large institutions lend to each other for very short periods, often just overnight. Operating on that market is covered separately. follows within days, because the money lent there is lent overnight and gets re-lent tomorrow at whatever tomorrow's price is. A bank's own money was contracted on all sorts of dates for all sorts of lengths, so what the bank pays for it follows only over months. The rate quoted on a brand new loan follows that. The rate on a loan already running follows only when that particular contract reaches its own reset date. And the instalment follows the month after the reset, and not one day earlier.

Why does each link in the chain run on its own clock?

Because a rate can only change when something is being priced anyway. Every delay in the chain comes out of that one fact, and the fact is worth turning over slowly.

Money lent overnight is priced every single day. Whatever was agreed yesterday is finished this morning, and this morning somebody has to agree a fresh number. So when the authority moves, that market has no old contracts to work through: by the second or third morning almost the entire change is sitting in the price. The money market is quick for that reason alone, and the quickness has nothing to do with anybody being cooperative.

A three year deposit is priced once, on the day it is taken, and then not again for three years. A twenty year housing loan at a rate fixed for the whole term is priced once and never again. Between those two extremes sits everything else, each with its own tenorHow long a deposit or a loan runs before it has to be repaid or renewed. A short tenor comes up for renewal sooner and so gets repriced sooner. and its own renewal date, and each of those dates was set before anybody knew a cut was coming.

Each link can only start moving once the link above it has actually moved. The delays therefore do not overlap and do not cancel out, and the time to the instalment is the sum of the waits rather than the longest of them. That is the difference between a chain and a race. If the six links were racing, the whole thing would be done in the time the slowest one took. The links are not racing. A bank's cost of money cannot fall until the money market has fallen and the deposits have matured; the rate on a new loan cannot fall until that has happened; and the instalment on a loan already running cannot fall until both have happened and the contract has also reached its own reset date.

How interest rates transmit through banks, and where transmission ends

A bank's own funding is the link where the delay actually lives, and it has a hard edge, beyond which the subject becomes banking rather than policy.

Here is the whole of it in ordinary words. A rate charged on lending has to cover what the lender paid for the money it is lending. The lender's money is not one lump taken this morning. The money is a mixture: deposits taken last week, last quarter and three years ago, each for a different length and at whatever the price was on the day it was taken, plus borrowings arranged on their own dates. When the policy rate falls, not one rupee of that existing mixture becomes cheaper. Only the next rupee does, and only when the old one matures and has to be replaced.

A lender is not being obstructive when its rates move slowly, it is working through a book of money that was contracted before the cut and cannot be un-contracted. Think of a canteen that has already bought the month's rice at last month's price. Rice gets cheaper on the tenth. The canteen's cost does not fall on the tenth. The cost falls when the sack runs out and the next sack is bought, and if the canteen keeps three months of rice, the cheaper price shows up in the thali rate a quarter later. Nobody in that canteen is holding out on anybody.

And now the edge. Everything above stops at the shape of the problem: money was contracted earlier, it costs what it cost, and it reprices as it matures. How a lender actually builds the number it quotes, what spreadThe gap a lender keeps between what its money costs it and what it charges. How wide the gap should be, and what decides it, belongs to banking rather than to policy. it holds on top, which benchmark it links a product to, and how it chooses between deposits and market borrowing to fund itself are all banking questions with their own machinery, and they are covered under banking and lending. Transmission does not require any of them. Transmission requires only one fact: the money is a mixture contracted before the cut.

How much of a 100 basis point cut actually arrives?

Now put numbers on it. The Republic of Sankhya, an invented economy, announces a cut of 100 basis pointsOne hundredth of one per cent. A hundred basis points make one full percentage point, so a rate moving from 9.50 per cent to 8.50 per cent has moved a hundred of them., which is one full percentage point.

Within days, the overnight money market has taken 95 of those 100 basis points. The money market is the fast link, for the reason just given: everything there is priced tomorrow anyway. Then the slow part begins. After one quarter, the rate quoted on new business lending has come down by 40 basis points. After two quarters, 60. After three, 72. After four, 78. And there it stops.

The money market received 95 per cent of the cut almost immediately and a borrower received 78 per cent of it after a full year, and the distance between those two numbers is what transmission means. The last column carries the shape. The first quarter delivers 40 basis points, the second adds 20, the third adds 12, the fourth adds 6. Each quarter delivers roughly half of what the one before it delivered. Working through a book of contracts looks like that from the outside: a rush, then a trickle, then a stall.

Where did the missing 22 basis points go?

Most accounts of the subject wave at that question, and waving at it is what makes the rest of the arithmetic useless. If 78 arrived and 100 was announced, 22 basis points are unaccounted for, and they are not a rounding error. The missing 22 went somewhere, and there are exactly three somewheres.

Nine of them are late rather than lost. The nine sit inside deposits and borrowings taken before the cut, and those contracts go on paying the old price until the day they mature. When those mature in the fifth, sixth and seventh quarters, they get replaced at the lower price, and some of those nine basis points show up in lending rates then. An account that stops counting after four quarters records them as missing; they were only slow.

Eight of them were absorbed. The eight sit in the gap a lender holds between what its money costs and what it charges. Nothing about the risk of not being repaid changed when the policy rate moved, and so the gap did not narrow. A cut makes money cheaper. A cut does not make borrowers safer. So the part of the rate that exists to cover the chance of not being repaid has no reason to fall at all, and it does not.

Five of them will never arrive. The five belong to lending written at a rate fixed for the whole term, with no reset date anywhere in the contract. The cut has nowhere to land on those loans, this year or in any year, and no amount of waiting changes that.

What does the arrived cut do to an actual instalment?

Here is where most writing on this subject stops, one link too early. An account that ends at 78 basis points has described a lending desk. Such an account has said nothing about the person whose salary the instalment comes out of. The last step remains.

A household in Sankhya has a housing loan of Rs 30,00,000/- at 9.50 per cent, running for 20 years, or 240 monthly instalments. The loan is on a rate that resets. When the rate quoted on new lending moves, this loan follows at its next reset. After four quarters, 78 of the 100 basis points have arrived, so 9.50 per cent has become 8.72 per cent.

Put 9.50 per cent through it. The monthly rate is 9.50 divided by 1,200, or 0.00791667. With 240 months that gives an instalment of Rs 27,964/-, rounded to whole rupees. Put 8.72 per cent through the same formula, with a monthly rate of 0.00726667, and the instalment is Rs 26,454/-.

The instalment falls from Rs 27,964/- to Rs 26,454/-, a drop of Rs 1,510/- a month or 5.40 per cent, and Rs 3,62,400/- across the full 240 months. A 100 basis point cut looked like that to one household a year after it was announced. Check the term figure yourself rather than taking it: Rs 1,510/- a month multiplied by 240 months is Rs 3,62,400/-, and the same number falls out of the totals, because 240 instalments of Rs 27,964/- come to Rs 67,11,360/- and 240 instalments of Rs 26,454/- come to Rs 63,48,960/-.

The shape of the fall is the same one the pass-through schedule had. Watch it happen quarter by quarter. The reducing balanceAn arrangement where interest is charged each month on what is still owed rather than on the original amount, so the interest share inside each instalment shrinks as the loan runs down. arithmetic does not distort it; it passes it straight through.

Every entry in the fall column is a positive amount taken off the instalment. The table says fall rather than putting a sign in front of a number. The first quarter takes Rs 779/- off. The fourth takes Rs 115/- off. If this household had stopped paying attention after two quarters, they would have concluded that the cut was worth Rs 1,165/- a month, and they would have been reading a journey that was not finished.

Why does the same cut reach two borrowers differently?

Everything so far has followed one borrower. Now put three of them side by side, all in Sankhya, all hearing the same announcement on the same morning, and watch the same 100 basis points arrive as three completely different amounts.

The first is the household already described. Their loan resets, so the cut reaches them at their next reset date, arriving as 78 basis points after four quarters and taking Rs 1,510/- a month off the instalment. The second borrowed at a rate fixed for the whole 20 years, at 9.50 per cent, in exchange for knowing the number would never move. The rate has not moved. Their instalment is Rs 27,964/- this month and it was Rs 27,964/- before the announcement. Nothing arrived, and nothing was supposed to.

The third never got a loan. The application went in, and the credit appraisalThe checks a lender runs before agreeing to lend: what the borrower earns, how steady it is, what is already owed and what can be pledged. The content of those checks is covered under lending. said no, because their income was too irregular to document or they already owed too much against it. For them the cut is not smaller. The cut is absent. A cheaper rate is a rate on a loan they do not have, and there is no arrival date at which it starts to matter.

A cheaper rate reaches nobody who fails the test to get the loan. Policy discussions argue about the price of credit. The third borrower never got as far as access to it, and that case is the one such discussions forget. The picture below puts the three panels on identical geometry so the difference is impossible to argue with. Read across the bottom row of all three.

What does a lender watch while all of this is happening?

The working habit on the other side of the counter is duller than it sounds and follows directly from everything above. A lender watches its own repricing calendar. The calendar decides when a lender's numbers move.