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Explained: How are inflation rate and interest rate linked?

At present, the Indian central bank is facing an odd situation: GDP is contracting even as inflation is rising.

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The Monetary Policy Committee of the Reserve Bank of India from August 4 to 6, 2020. (Express Photo: Pradip Das)

India’s central bank, the Reserve Bank of India, decided to keep the benchmark interest rates of the economy unchanged on Thursday. The decision was taken after three days of deliberations by the Monetary Policy Committee of the RBI.

Going into the bimonthly review of monetary policy on August 4, there were varying expectations from the RBI. There were people who expected the RBI to cut the repo rate — the interest rate that the RBI charges when the banking system borrows from it — given the increasingly worsening forecast about India’s economic growth.

To be sure, forecasts for India’s gross domestic product (GDP) growth have been rolled back sharply ever since Covid-19 disruption hit the economy. At present, most experts expect the economy to contract sharply — by as much as 10 per cent — in the current financial year. There were others who expected the RBI to stay put and avoid cutting the repo rate because retail inflation — the key variable that RBI is supposed to target — had been above the RBI’s comfort zone for most of this calendar year.

Eventually, the RBI’s MPC unanimously chose to maintain the status quo on the repo rate.

What is the link between growth, inflation and interest rates?

In a fast-growing economy, incomes go up quickly and more and more people have the money to buy the existing bunch of goods. As more and more money chases the existing set of goods, prices of such goods rise. In other words, inflation (which is nothing but the rate of increase in prices) spikes.

To contain inflation, a country’s central bank typically nudges up the interest rates in the economy. By doing so, it incentivises people to spend less and save more because saving becomes more profitable as interest rates go up. As more and more people choose to save, money is sucked out of the market and inflation rate moderates.

Explained: The two reasons why RBI did not cut interest rates, contrary to expectations

What happens when growth rate decelerates or contracts?

When growth contracts, as is happening in the current financial year, or when its growth rate decelerates, as was happening right through 2019, then typically, people’s incomes also get hit. As a result, less and less money is chasing the same quantity of goods. This results in either the inflation rate decelerating (that is, prices grow at 1% instead of 5%; also called “disinflation”) or it actually contracts (also called “deflation”; that is, prices reduce by 1% instead of growing at 5%).

In such situations, a central bank nudges down the interest rates so as to incentivise spending and by that route boost economic activity in the economy. Lower interest rates imply that it is less profitable to keep one’s money in the bank or any similar saving instrument. As a result, more and more money comes into the market, thus boosting growth and inflation.

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Why has RBI not raised interest rates when retail inflation has been above the comfort zone of 2 to 6% for most of the year?

RBI is facing an odd situation at present: GDP is contracting even as inflation is rising. This is happening because the pandemic has reduced demand, on the one hand, and disrupted supply on the other. As a result, both things are happening — falling growth and rising inflation.

It is true that for containing inflation, RBI should raise interest rates. And under normal circumstances, it would have done just that. But raising interest rates at this stage would be catastrophic for India’s GDP growth.

However, RBI could not have cut the interest rates as well because the inflation rate has been above the 6% mark for all the months in 2020 barring March. If the RBI cuts the interest rate, it may be fuelling retail inflation further. It must be remembered that inflation hits the poor the hardest.

So, the RBI has chosen to do what many expected it to do: stay put and wait for another couple of months to figure out how growth and inflation are shaping up.

It will take a call in October when the MPC reconvenes to calibrate the monetary policy.