Illustration: Katmandu Journal
A change in a central bank’s policy interest rate ought to be felt across an economy. When the rate soars, the cost of borrowing should, too, causing businesses and households to think twice before taking out loans. That, in theory, cools demand and tames inflation. In most rich countries, this “pass-through” from policy rate to lending rate is fast and substantial. But in many developing economies, the chain of causation is more fragile. A new study from the Nepal Rastra Bank, the country’s central bank, examines how the mechanism works in a low-income, bank-dominated financial system. The findings are a little surprising.
Nepal confers a compelling case study. It adopted an interest-rate targeting framework only in 2017, making its experience modern as well as measurable. Its economy is heavily dependent on banks, which in turn rely on deposits from ordinary savers rather than on professional money markets. This structure creates “financial frictions”: jolts and delays in the system that can weaken the central bank’s influence. The NRB paper asks this question: when it changes its policy rate, do banks adjust their lending rates, and if so, by how much?
Dig deeper: How the NRB conducts monetary policy
The research uses monthly data from 2004 to 2025, with a closer focus on the period after the new framework was introduced. It employs several econometric techniques to isolate the effect of a policy-rate shock. The core approach, called “local projections”, tracks how a bank’s base rate (the benchmark for its lending) responds over subsequent months. To ensure robustness, the authors also use more complex methods that account for the fact that many economic variables move together. The results hold up across different models.
They show that pass-through is immediate but incomplete. When the central bank raises its policy rate by one percentage point, the average base rate at commercial banks begins to rise within a month. Yet the increase peaks at only about half a percentage point, and does so nearly a year later. Monetary policy works, but it is muffled. Banks do not fully transmit the central bank’s signal.
Further analysis shows that this muted response is not uniform. When base rates are unusually low, a policy-rate increase is passed on almost fully and quickly. But when rates are already high, banks are far more reluctant to lift them further. This may be because they fear losing customers when credit is already expensive. Similarly the state of banks’ liquidity matters. When they are flush with excess reserves—when deposits surpass the demand for loans, as they do now—the pass-through is stronger. A cash-rich bank in a sluggish lending environment has more room to adjust its rates.
What accounts for the general stickiness? The study points a finger squarely at the structure of the deposit market. A big share of bank funding comes from fixed-term deposits, whose interest rates are locked in for months or years. When the central bank changes its policy rate, banks cannot quickly adjust what they pay to many of their depositors. Their own cost of funds is therefore slow to change, making them hesitant to alter what they charge borrowers. It is as if a chef is told to change a dish’s final flavour, but must wait for a key ingredient to be replaced.
A common suspicion is that weak competition among banks lets them ignore central-bank moves. If a handful of lenders dominate the market, they could resist raising deposit rates or delay adjusting lending rates, padding their profits at the economy’s expense. The NRB study finds no evidence for this. Market concentration, it concludes, does not explain the sluggish pass-through. The culprit is the deposit base itself and not the number of banks.
The implications are big. Nepal’s economy is also characterised by a huge informal sector, estimated to constitute over two-fifths of output, and a stagnant property market. These further weaken the transmission of monetary policy, as central-bank signals fade before reaching vast swathes of economic activity. The stock market, another potential transmission channel, shows only a feeble and statistically unreliable response to rate changes.
The lesson for policymakers is that financial infrastructure matters as much as financial policy. The NRB can tweak its rates with precision, but without ambitious reforms its actions will be partly muted. The study suggests discouraging the current over-reliance on large, inert fixed deposits from public-sector institutions. It also recommends developing a more vibrant money market and encouraging corporate bonds, so that big firms are not wholly dependent on banks for funding. This would improve monetary-policy transmission and allow banks to focus on lending to smaller businesses and households.
The central bank has shown that its voice can be heard in the lending halls of its commercial banks. But for its words to carry their full weight, the financial system through which they travel must become less congested. The journey from policy rate to base rate is a short one. The journey from there to a more dynamic economy is much longer. ■
