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Why should the RBI reduce interest rates?

india Updated: Oct 12, 2007 22:53 IST
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In the last one year the rates of interest were jacked up a hefty 2 per cent. There were, no doubt, reasons. Inflation had crossed 6.2 per cent in March and, to restore stability, interest rates had to be raised. That is what most central bankers do.

How does an increase in interest rate help stabilize prices? Simple. With increase in interest rates demand for a variety of goods shrinks. Consumers buy less of durables, potential home owners postpone purchase of houses, companies delay investment and so on. All in all, demand is reduced so that it may match available supplies. That stops prices from shooting up.

That is really what seems to have happened. Demand for homes dropped; so also for cars, refrigerators, TV sets, and so on. As a result, industry had to cut production or go slow. In August, the rate of industrial growth came down to 7.2 per cent from 14 per cent in the same month last year. Inflation too was down and has steadied at less than 4 per cent since August.

That may give the impression that the increase in interest rate did its expected trick. Not quite. There was no doubt excess demand in the economy. But it was confined mainly to the agricultural sector which did not produce enough to keep the market in balance.

Since demand for most agricultural products is fairly inelastic prices of agricultural commodities rose. The interest rate did no work in agriculture where the excess demand was. It only hit industry where supplies are fairly elastic. Growth consequently declined.

The current scene is vastly different. The rainfall this year has been 5 per cent more than the long term average. Besides, areas under many crops are larger than what they were last year. As such, production this year will be much more and will hold back prices of agricultural products. On the contrary, industrial growth has slackened due to fall in demand. Liquidity in the banking system is high and there are fewer takers for credit. The high interest rate which discouraged credit attracted larger savings to bank deposits. Inflation is low and, with larger agricultural production, may not flare up in the near future.

The monetary conditions consequently are full of contradictions. High liquidity and high interest do not go together. High interest rate and low inflation do not go together. For commercial reasons therefore commercial banks have been tempted to act on their own to slash interest rate, without waiting for the RBI to give the signal. The 0.5-1 per cent cut in home loans and retail credit may have been partly motivated by the Finance Minister who naturally would not like interest rate to depress industrial growth and consequently tax revenue.

Since inflation is well below the RBI target, it is time that the RBI lowers the interest rate. The advantage is that it will accelerate industrial growth and keep the economy in its 9 per cent orbit.

(The writer is president, RPG Foundation rpgfoundation2000@yahoo.com )