Impact of Interest Rate on Indian Economy

RBI takes into account various factors like world macro-economic

environment, Indian economic and industrial activity, inflation, liquidity,
trade, exchange rate etc. before arriving at the monetary policy. Their
main objective of RBI is the price stability in the economy while keeping
the growth prospects in mind.
RBI has cut 150 bps (1.5%) since last January and the clamour has been to
cut more rates but governor, Mr. Raghuram Rajan has refrained from
doing so. The objective of this article is to analyse the impact on macroeconomic parameters had RBI given more rate cuts by now and the future
expectations.
Inflation: One of the most important objective of RBI is to contain high
inflation i.e. to bring inflation within the target level which is 5% by
2017. Had RBI given more cuts, the inflation would have been higher
especially when we had two consecutive draught years. With supply
side already strained, the more expansionary stance of RBI would have
resulted in more demand which would have increased retail inflation
and resulted in higher food prices.
Deposit and Lending Rates: Though the RBI has cut 150 bps but
banks have not passed down the reduced rates cuts to customers
proportionately. With more cuts, banks would have been more confident
to reduce lending rates to the customers. This would have resulted in
more investments from private sector and spur growth. Also
consumption of households would have also increased which would
have revived the economic cycle in the country. Hence RBI has
introduced marginal cost of funds based lending rate (MCLR) from April
16 onwards for effective monetary transmission in which interest rates
will reflect the change in monetary policy.
Currency or Foreign Exchange Rate: We know the value of currency
is directly proportional to interest rates. With high interest rate the
demand of the currency increases as it gives higher return and the
currency appreciates. If RBI had decreased the interest rate by 3-4%
then the value of Indian rupee would have depreciated significantly.
This would have helped our exports but since India is a net importer of
goods and services, our current account deficit might have widened.
RBI always keeps an eye on US fed decision on whether they are
increasing the rate or not because an increase in interest rate in US and
a decrease in rate in India would encourage investors to put their
money in US resulting in capital flight. Moreover the rate cut of around
3-4% might have signalled the world that India is intentionally
devaluing its currency to be competitive in the world market just like
China and it might have resulted in currency war.

 Unemployment Rate: Lower Interest rate would have made

availability of capital cheaper, encouraging companies to expand and
hire more people. This would have resulted lower un-employment rate.
But interest rate alone cannot spur the growth, there are other equally
important factors like government policies, regulations, easy of doing
business, infrastructure etc. which improves business environment in
the country.
Bond Market: People who invested in bonds before the RBI decided to
start rate cuts would have gained had RBI cut the rate by some more
percentage since bond prices are inversely proportional to interest rate.
But the rate cut has been only 150 bps till now, they have clearly not
gained as much as they could have.
Savings: Lower interest rate would have led to lower savings rate. This
means people living on income from savings account would have
suffered like pension funds, PPF. As we can see PPF rate might fall below
8% for the first time in 48 years. [Source: Economic Times]
Equity Market: More accommodative stance of RBI would have
brought cheers in the equity market. As the investment in fixed income
securities like bonds and deposits would have given less return, people
would have been encouraged to invest in equity market. Also more
consumption from the people as they would have borrowed at lesser
rate would have increased the top line for the companies. With good top
and bottom line, the institutional investors who form major chunk in
equity market would have also brought in more money in the market.
Future Prospects
Now RBI maintained the policy rates in a recent monetary policy review,
we look at some of the factors that would determine the future policy rate
cuts.
Monsoon: After 2 years of draught, this year monsoon is expected to
be above normal which is a good news for farmers. It would take care
of the supply side and leave more room for rate cuts in the future.
Inflation: CPI increased to 5.77% y-o-y which is above the market
expectations of 5.73 percent. This is a cause of concern and further
rate cut would exacerbate the situation of inflation. Even government
whose consistent stand is to have more rate cut would not like to have
high inflation in coming months as some of the important elections are
due next year where inflation can become an election issue.
Introduction of 7th pay commission and One Rank One Pension
Scheme could bring in more money in the hands of people which can
affect inflation and hence future monetary policy review would take
these factors into consideration as well.

 IIP: The general index stands at 181.8 in May 2016 which is 1.2 %
higher as compared to May 2015 but the cumulative growth for AprilMay 2016 over the previous year is at
-0.1% suggesting RBI to
have loose monetary policy.[Source: MOSPI]
World factors: Global factors like Fed rate hike, Brexit, Oil prices,
trade figures, chinas economic factors may also play role in future
monetary policy reviews.
Exit of Dr. Raghuram Rajan: Now that Dr. Rajan has decided not to
take up 2nd term, a lot would depend on his successor who would be
under pressure to reduce the rate to revive the growth cycle.
With all the above factors in mind, we expect RBI to have more
accommodative monetary policy in the future.