The movement of interest rate affects different economic agents — consumers, investors, manufacturers and economy — differently. It is guided by a number of factors — both domestic and international. It is one of the key macro- economic indicators not only influencing other macro indicators but also impacted by other macro-economic indicators. Savings, investments, currency movement, deficit, liquidity are some key indicators that influence interest rate movement. Interest movement influences demand, inflation, investment and growth of the economy. Inter-relationship between these variables is multidimensional and a complex web.
Interest rate is a powerful tool in the armoury of monetary authorities to fight inflation and guide movement in consumer/ investment demand. During the phase of rising inflation, monetary authorities use higher interest rate to manage demand and asset price bubble. However, it is not very successful in controlling food inflation.
India witnessed a phase of higher consumer inflation, although a large part of it has originated from food inflation and monetary authorities tightened monetary policy to control inflation. Since December 2014, retail inflation started falling.
Initially due to high base effect and then due to sharp correction in global crude prices, which corrected by nearly 50 per cent. However, in last two months retail inflation has again started increasing due to higher food inflation. Due to the decline in retail inflation, the clamour for a sharp cut in RBI rate started increasing. In 2015, RBI has reduced repo rate by 0.5 per cent. But banks did not pass it to consumers till this week, citing a high cost of funds as a reason.
In last monetary policy review on April 7, RBI although maintained status quo on interest rate, it prodded banks to pass on the benefit of the previous rate cut to the consumers, which few banks did.
Effect on consumers
How is it going to benefit the economy in general and consumers in particular? Will it lead to boosting the consumer demand and investment leading to high growth? An immediate benefit of 0.15 to 0.25 per cent reduction in the base rate by banks will translate into reduction in loan EMIs.
Theoretically, this will lead to an increased demand and a higher growth. However, given the present situation, this can’t be taken as given, due to the risk-adverse behaviour of households facing the brunt of sustained inflation for several years.
Although retail inflation in Q3 FY15 declined to five per cent from 10.4 per cent a year ago and 7.4 per cent in Q2 FY15, the growth in private final consumption expenditure in Q3 FY15 fell to 3.5 per cent from 8.7 per cent in Q2 FY15.
This suggests despite a decline in inflation, consumers are not ready to start consuming. Consumers are really hit hard by high retail inflation in last few years. The average retail inflation during FY10-FY14 was 10.2 per cent. Hence consumers are holding their purchase back, which is evident from the production growth of consumer durable goods (April-January FY15 IIP growth: -14.2%).
Interest rate on decline
RBI has maintained a status quo in the last monetary policy, another 0.5 per cent cut in the repo rate during FY16 is possibile. All other factors affecting interest rate in the economy are expected to perform better in the medium term.
A lower fiscal deficit of the government will improve liquidity in the market and ease liquidity pressure. This will help in cooling the call money rate in the money market and thus lower cost of funds for banks and interest rates for consumers.
Inflation outlook at least for FY16 is benign, which would lead to higher savings and finally impacting the bank lending rate. In the middle of 2013, the rupee was one of the worst performing currencies and was one of the global fragile five currencies. Since 2015, the rupee has been one of the best performing emerging market currencies. A stable currency is also likely to affect interest rate.
What can spoil a happy story?
Obviously, it is again inflation. One of the major factors behind pushing inflation rate higher, apart from food inflation, was slower addition in capacity. A dream economic run during FY04-FY08 resulted in demand growth higher than the capacity additions and we ended up in classical overheating situation.
In order not to get caught in the same situation again, the government should focus on capacity augmentation both in farm and non-farm sector. While some sectors are having under capacity, some other sectors are facing excess capacity issues. During FY04-FY08 both domestic and global economic growth was at its boom stage and capacities in some sectors were added assuming strong demand to be permanent.
However, after global financial crisis, the global demand has yet not returned to the pre-crisis level and if inflation does not remain under control, then we may witness prolonged phase of low growth, higher inflation and high interest rate.
